Extraordinary Items in the Financial Results

Many companies have a curious line item in their financial results called "Extraordinary items". This is an extremely important piece of information and needs proper analysis because investors are easily swayed by this number.

The meaning of extraordinary item is that the item is realized and applicable only for this particular quarter/year/financial result. Suppose that a company makes pencil boxes and each box costs Rs. 5 to the company. The company incurs other costs of electricity, distribution, labor etc at the rate of Rs. 2 per box. Finally, the selling price for this box is Rs. 10.

In this case, the operating profit to the company is Rs. 3 per box. If the company sells total of 100 boxes, the operating profit will be Rs. 300.

Now suppose that a machine in the factory is lying idle for a long time and company decides to sell it for Rs. 200. Now, this particular transaction is applicable only for a single time and can not be repeated quarter after quarter. So the proceeds of Rs. 200 come under the title of Extraordinary Items. This transaction however boosts the net profit of the company to Rs. 500.

See that the EPS for this particular quarter of the company will suddenly go up hugely (by 67% in this case) and it will seem that company has really performed well. However note that operating profit is still same Rs 300.

We should note that true value of a company is a function of operating profit, and NOT the net profit. So the next time you are about to invest in a share which has delivered fantastic results, always make an effort to find out if the results are boosted by the extraordinary items or the actual operating profit.

In real world Discounted Cash Flow valuations of the companies, analysts very carefully take out this extraordinary line items and valuations change only when operating profits change.