Evaluate quality of earnings
Response to the following problem:
Prudhoe Bay Oil Co. is having its initial public offering (IPO) of company stock. To create public interest in its stock, Prudhoe Bay's chief financial officer has blitzed the media with press releases. One in particular caught your eye. On November 19, Prudhoe Bay announced unaudited earnings per share (EPS) of $1.19-up 89% from last year's EPS of $0.63. An 89% increase in EPS is outstanding! Before deciding to buy Prudhoe Bay stock, you investigated further and found that the company omitted several items from the determination of unaudited EPS:
¦ Unrealized loss on available-for-sale investments, $0.06 per share
¦ Gain on sale of building, $0.05 per share
¦ Prior-period adjustment, increase in retained earnings, $1.10 per share
¦ Restructuring expenses, $0.29 per share
¦ Loss on settlement of lawsuit begun five years ago, $0.12 per share
¦ Lost income due to employee labor strike, $0.24 per share
¦ Income from discontinued operations, $0.09 per share
Wondering how to treat these "special items," you called your stockbroker at Merrill Lynch. She thinks that these items are nonrecurring and outside Prudhoe Bay's core operations. Furthermore, she suggests that you ignore the items and consider Prudhoe Bay's earnings of $1.19 per share to be a good estimate of long-term profitability.