What is growth? – Growth is often used with a variety of meanings Growth in sales Growth in earnings Growth in assets – Our focus will be identifying growth in sustainable earnings 1

Identify earnings on which growth is possible – Core earnings (also sustainable earnings, persistent earnings, underlying earnings) Earnings that can repeat in the future and grow – Transitory earnings (also unusual items) Earnings based on temporary factors Also includes items that appear each period but can’t be forecast --- e.g. dirty surplus items 2

Operating income = core operating income + unusual items = core operating income from sales + core other operating income + unusual items 3

4 Reformulated Operating Income (1) Core operating Income Core sales revenue - Core cost of sales = Core gross margin - Core operating expenses = Core operating income from sales before tax - Tax on core operating income from sales + Tax as reported + Tax benefit from net financial expenses - Tax allocated to core other operating income - Tax allocated to unusual items = Core operating income from sales

5 Reformulated Operating Income (2) Core other operating Income + Equity income in subsidiaries + Earnings on pension assets + Other continuing income not from sales - Tax on core other operating income (1) + (2) = Core operating income

6 Reformulated Operating Income (3) Unusual items - Special charges - Special liability accruals +/- Nonrecurring items - Asset writedowns +/- Changes in estimates - Startup costs expensed +/- profits and losses from discontinued operations +/- extraordinary operating items +/- accounting changes +/- unrealized gains and losses on equity investments + Gains from share issues in subsidiaries +/- Currency gains and losses +/- Derivative gains and losses - Tax allocated to unusual items = (1) + (2) + (3) = Comprehensive operating income

Issues in identifying core operating income 1.Deferred (unearned) revenue 2.Restructuring charges, asset impairments, and special charges 3.R&D 4.Advertising 5.Pension expense 6.Changes in estimates 7.Realized gains and losses 8.Unrealized gains and losses on equity investments 9.Unrealized gains and losses from applying fair value accounting 10.Income taxes 11.Other income 7

Core operating profitability 8  To the extent that RNOA is driven by UI, it is said to be of “low quality”, i.e., it is not sustainable