Are Special Items Informative About Future Profit Margins?

Abstract

Most proponents of using profit margins in a forecasting model suggest that unusual items be removed from income to create a "core" profit margin. We investigate the appropriateness of this assumption over short and long horizons. Specifically, we explore the association between profit margins and special items over windows of increasing length, from one to five years. We find the association between past special items and future profit margins differs markedly between firms with low and high core profitability. For low profitability firms, past special items have no association with future profit margins, even over windows of five years. In sharp contrast, for high profitability firms, negative special items are associated with lower future profit margins. This suggests that some firms maintain high core profitability by becoming serial chargers and special items differ from core earnings only to the extent that the allocation process induces timing errors in reported earnings.

Keywords: Special items, persistence, core earnings, earnings aggregation, profit margins

JEL Classification: M41