What is the Instability Index of Earnings?

The instability index of earnings reveals the deviation between an entity's long-term trend of income and its actual income. When the index is quite high, it indicates that a firm is unable to sustain a consistent pattern of earnings. Thus, an organization with a high instability index is riskier than one with a lower index. The primary implication of a high instability index for a firm is that it has a lower valuation than a firm with a lower index. This can significantly impact the price that an investor might be willing to pay for the shares of a firm, or the price that a potential acquirer might be willing to pay for a target company.

A key consideration when calculating the index is the duration of the period used to compile the income trend line that serves as a baseline for the calculation. When the period spans a large number of years, the earlier years incorporated into the trend line may contain data points that differ significantly from the income figures reported for later years, and which could therefore have a notable impact on the reported deviation. The person running the calculation should examine the income figures for all periods included in the trend line calculation, to see if the duration of the trend line will cause unusual results to be reported.