Earnings Persistence and Sustainable Earnings Measures

Overview

Earnings persistence is all about determining whether a company’s current level of profitability will hold steady (or grow) into the future. This idea matters because, let’s face it, investors hate big surprises—especially unpleasant ones. When earnings show lower variability and reflect the core recurring operations of a firm, it’s typically a sign of a higher-quality, more predictable investment. Sustainable earnings exclude oddball, one-time events—like a big asset sale or a random litigation windfall—so that what remains essentially represents the company’s real underlying profitability. If you’re a portfolio manager, an analyst, or, well, anyone who wants to make an informed decision about a stock, you need to get good at spotting how much of that bottom line is actually repeatable.

Below, we’ll explore the notion of earnings persistence, why it’s an essential piece of the valuation puzzle, and how to disentangle “good” earnings from “here today, gone tomorrow” windfalls. Let’s jump in.

The Concept of Earnings Persistence

Picture yourself analyzing a firm that has had fairly stable earnings over the last five years—no massive jumps or random spikes. When you get an even deeper look, you realize those earnings come mostly from consistent product sales or subscription-based revenues. That’s a big clue those earnings could persist into future periods. High earnings persistence stems from:

• A stable customer base.
• A credible brand or patent-protected product.
• Reliable, recurring sales channels like repeat subscriptions, annual maintenance revenue, or established supply agreements.

From a capital markets standpoint, persistent earnings command higher valuation multiples. Why? Because if markets believe these earnings aren’t likely to vanish soon, then a smaller discount rate gets attached to that stream of future cash flows, and analysts might be willing to project them several years into the future with confidence.

But watch out: smooth earnings don’t automatically mean they are persistent. Sometimes unscrupulous management might use earnings management techniques—like classification shifting or channel stuffing—to manufacture apparent stability. That’s why you want to dig into footnotes, read the auditor’s commentary, and keep an eye out for odd changes in operating metrics.

Sustainable Earnings vs. Transitory Items

If you think about a single quarter in a firm’s life, you may see a bunch of numbers splattered across the income statement. These could come from selling goods or services, which is presumably the company’s core business, or from something completely offbeat, such as disposing of a division or winning a huge lawsuit. The difference between a recurring revenue stream and a one-time event is critical in analyzing sustainable earnings.

• One-time items (transitory): Gains from asset disposals, extraordinary litigation settlements, severance packages from staff layoffs, or, ironically, a dash of profit from foreign currency hedges that might not happen next period.
• Recurring items (sustainable): Earnings from ongoing product lines, subscription fees, or everyday services.

In practice, you might see a firm touting its “core” EBITDA by removing items like restructuring charges or M&A integration costs. These adjustments aim to show a sort of “pure” operational number. However, you should verify if such adjustments are fair. If a company “restructures” every single year, is that truly a non-recurring event? Probably not.

Identifying Highly Persistent Earnings

Highly persistent earnings typically display:

1. Low Volatility: You see stable patterns in gross margin, operating margin, or net margin. This can be further confirmed by analyzing multi-year trends and ratio analysis (see “Analyzing Income Statements” in Chapter 2 and “Financial Analysis Techniques” in Chapter 13).
2. Consistent Business Model: A recognizable brand, a protective patent, or a strong supply chain that doesn’t change drastically every year. Think about large tech companies with robust subscription models—those typically exhibit stable revenue streams.
3. Solid Revenue Recognition Practices: When management uses transparent accounting policies (see IFRS 15 and ASC 606 guidelines), you can more easily ascertain the real pattern of revenue.

Anyway, it’s not all about being perfect. Firms go through expansions, recessions, strategic pivots, and so on. But high persistence is when, overall, you see incremental growth or consistent earnings across different economic cycles or business seasons.

Role of Competitive Advantage

Ever wonder why certain businesses hum along nicely year after year? Maybe they own a patent that bars direct competition. Maybe their brand recognition is so huge that folks keep buying their product almost out of habit—like how many of us always pick the same coffee brand at the grocery store, even if there’s a cheaper alternative next to it. Competitive advantages protect a firm’s market share and profit margins, often creating a moat around its core operational earnings.

If you’re analyzing a firm and see a patent set to expire or a competitor launching an equally good (or cheaper) product, you might start to question the firm’s earnings persistence. Without that protective moat, the company’s recurring revenue could dwindle, making the future less predictable and less valuable.

Adjusting EBITDA or Net Income for Sustainable Earnings

In many professional contexts, we see a measure called “Adjusted EBITDA.” This is typically:

EBITDA - (any unusual items like severance, impairments, or gains/losses on asset sales)

Some firms even use fancy custom labels: “Adjusted Operating Income,” “Non-GAAP Profit,” or “Core Earnings.” The underlying logic is to back out short-lived or one-time things.

But watch out—companies love to spin their story. Sometimes they remove items that might actually be an integral part of their recurring cost base. For instance, a tech startup that grants stock-based compensation every single quarter to a majority of staff might try to exclude that expense as if it’s a “non-cash item.” Technically it’s non-cash. But is it truly one-time if it appears consistently? Probably not. Such repeated “one-offs” should be flagged and recognized in your adjusted measure.

Multi-Period Analysis for Quality Assessment

Performing a multi-period analysis means you don’t just look at how the firm did this quarter or even this year. Instead, you line up multiple years (preferably at least three to five) on a spreadsheet, then examine:

• Revenue and Gross Margin Trends: Are they stable or do you see big jumps? Is growth erratic?
• Operating Margin and Net Margin Trends: Are these margins consistent, or do they fluctuate significantly because of non-recurring items like intangible asset impairments?
• EBITDA vs. Adjusted EBITDA: If you see the adjusted figure is consistently higher than reported EBITDA each year—by a sizable margin—why is that? Repeated restructuring? Ongoing litigation?

Keep in mind that sometimes repeated events (like regular restructuring) should be considered part of normal operations if they happen frequently enough.

Sustainable Growth Rate (SGR) and Future Forecasting

The Sustainable Growth Rate (SGR) approach says that a firm’s growth potential depends on its return on equity (ROE) and its retention rate (the fraction of net income reinvested in the business). If the company’s earnings are truly persistent and not inflated by transitory items, analysts can estimate how quickly it can grow using only internally generated funds. The typical formula for SGR is:

G = b × ROE

Where:
• G = Sustainable Growth Rate,
• b = Retention Ratio (i.e., 1 – Dividend Payout Ratio),
• ROE = Return on Equity.

But, if your net income number is full of ephemeral items, you might overestimate ROE. That leads to unrealistic growth assumptions in your valuation model or equity research. Precisely because of this, adjusting net income for transitory items is crucial to ensure the denominator in ROE is a reflection of recurring (and hopefully persistent) profitability.

Managerial Guidance and Footnote Disclosures

Don’t underestimate the power of footnotes—seriously. Sometimes, management explicitly tells you about certain events that impacted the quarter’s earnings. In footnotes, they might mention:

• Settlement income or other big legal items.
• Gains from partial disposal of a foreign subsidiary.
• Restructuring or plant-closure costs.
• Expected future cost savings.

By carefully reading those notes, you can figure out if these items really should be subtracted to get a better sense of sustainable earnings. Also pay attention to press releases and earnings calls. Management might discuss “next steps,” such as further cost synergies or expansions, letting you see if current revenue or expenses are truly ephemeral or set to continue.

Practical Example: Spin-Off Gains and Their Impact

Imagine Company X, a large manufacturing conglomerate, sells off an underperforming division. As a result, they record a one-time gain of $50 million. If you simply glance at the net income for that quarter, revenue might look artificially strong. But in reality, that $50 million won’t reappear next quarter. When constructing your normalized or sustainable earnings measure, you’d remove the gain from the spin-off and focus on what remains from continuing operations.

Personal Anecdote

I remember analyzing a mid-sized retail chain that’d had an amazing earnings spike two quarters in a row. At first glance, I thought, “Wow, they must have launched something that’s taking off.” But after digging into their statements, I found they’d had a series of inventory write-down reversals and, ironically, booked a tidy little gain after renegotiating a lease. Suddenly, the “impressive” performance didn’t seem as stable. It’s a classic reminder to look under the hood rather than rely on headline net income.

Diagrams: The Process of Identifying Sustainable Earnings

Below is a simple Mermaid diagram illustrating how analysts often prepare adjusted EBITDA for a multi-period analysis to identify sustainable earnings:

    flowchart LR
	    A["Start with EBITDA <br/> (Earnings Before Interest, Taxes, Depreciation & Amortization)"] --> B["Identify Non-recurring or Transitory Items <br/> (e.g., asset sale gains, restructuring costs)"]
	    B --> C["Assess Frequency & Materiality <br/> (Are these truly one-time?)"]
	    C --> D["Remove/Adjust Items to Create <br/> 'Normalized' or 'Adjusted EBITDA'"]
	    D --> E["Compare Across Multiple Periods <br/> to Evaluate Persistence"]

Strategies and Best Practices

• Compare Adjusted Earnings Over Time: Perform trend analysis on standardized adjustments—don’t just trust the company’s adjustments blindly.
• Corroborate Adjustments with Management Guidance: Do they say next quarter they won’t have these charges? Check their track record for accuracy.
• Cross-Check the Statement of Cash Flows: Identify how one-time items may appear in operating vs. investing sections to confirm the nature of gains or expenses (see Chapter 4, “Analyzing Statements of Cash Flows").
• Segments Matter: If the company has multiple divisions, break down performance by segment (see Chapter 1.8, “Segment Reporting Requirements"). You might find stable, recurring profit in one segment but big swings in another.

Pitfalls and Common Mistakes

• Over-Adjusting: Sometimes analysts remove so many items that the “core” earnings barely represent reality. Watch for repeated “non-recurring” charges that are actually frequent events.
• Ignoring the Long-Term Impact of “One-Time” Items: A large legal settlement might be labeled non-recurring, but the underlying business risk or operational disruption could persist.
• Failing to Recognize Industry-Specific Factors: Some industries, like extractive industries or cyclical sectors (e.g., metals and mining), have big fluctuations that might look like “one-offs” but are actually the nature of the business.

Exam Perspectives

On the CFA exam (particularly at advanced levels), you might see scenario-based questions requiring you to identify which items in a financial statement are likely transitory vs. sustainable. Or you might need to calculate an adjusted earnings figure or evaluate the plausibility of a company’s forecasted growth. Remember to think critically about whether an item is truly a one-time event—or if it’s a recurring part of their cost/income cycle. The exam might also test your knowledge of IFRS vs. US GAAP rules on classifying unusual items within the income statement.

Conclusion

Earnings persistence is a cornerstone of sound financial analysis. Persistent, stable earnings can be a powerful indicator of an organization’s operational strength, pricing power, and moat. Conversely, wild quarter-to-quarter swings or large lumps of gains from unusual events might point to shaky ground that you wouldn’t want to bank on for the long term. The skill of dissecting financial statements to strip out “noise” and reveal the core sustainable earnings is invaluable. By consistently applying multi-period analysis, checking footnotes, and understanding the business model’s fundamentals, you can hone in on the “real deal” beneath headline figures.

Take your time, do your due diligence, and you’ll have a better chance at spotting companies with truly sustainable profits—and avoid chasing illusions created by short-term accounting quirks.

References and Further Reading

• CFA Institute’s “Equity Asset Valuation” (Wiley Finance).
• Fairfield, P. M., & Yohn, T. L. (2001). “Using Asset Turnover and Profit Margin to Forecast Changes in Profitability.”
• McKinsey & Company. (2010). “Valuation: Measuring and Managing the Value of Companies.”
• For deeper details on IFRS vs. US GAAP approaches to revenue recognition, see Chapter 2.12 of this volume.

Tips for the Exam

• Watch for repeated “non-recurring” items—these might be more recurring than you think.
• Quickly evaluate footnotes and management commentary for disclaimers on big windfalls or unusual charges.
• Practice adjusting net income for unusual items in a multi-period setting. The exam might require making these adjustments for ratio analysis.
• Be prepared to address real-world complexities: a “one-time” expense might have multi-year ramifications.
• Time management: The constructed-response (essay) portion often demands a concise explanation of why an item is included or excluded from sustainable earnings.

Test Your Knowledge: Sustainable Earnings and Earnings Persistence