Understanding Valuation Earnings Adjustments

Valuations are prepared on the notion that value is prospective; in other words, the value of a business or asset is based on the returns one anticipates could be generated in the future. In the absence of having forecasts, Valuators often look at past performance as a proxy for future results. In doing so, there is a need to understand what the ‘maintainable’ earnings of a Company are. Events, circumstances and discretionary decisions of the shareholder may have impacted historic results, such that when determining the value of a company and its future earnings potential, there is a need to “normalize” historic results.

Why do we care?

Adjustments can have a material impact on value. So how are the adjustments determined?

There is no precise method or formula to determine the range of normalized earnings. Quantitative and qualitative analysis is often required to identify major trends in the historic results. While there is an extensive list of analysis that can be done, depending on the type of engagement it is, (i.e. Calculation, Estimate or Comprehensive) the starting point involves looking at historical earnings. The valuator should look at a period of years immediately prior to the valuation date. It is optimal to include a complete business cycle, therefore the number of historical years reviewed may vary depending on the nature of the industry. Some of the quantitative analysis applied may be trend, ratio and common-size analysis. Adjustments may also be determined through discussions with shareholders and management.

The goal of the analysis is such that the adjusted earnings become useful in estimating what the business can earn in the future. Some of the common adjustments may include:

1. Non-recurring and Non-operating Revenue and Expense items

One-time or non-reoccurring expenses are unusual in nature that are generally unrelated to the ordinary and typical activities of a business. These expenses may be infrequent in occurrence and not expected to recur in the future.

Some examples may include discontinued operations, lawsuit settlements, start-up costs, moving costs, costs associated with labour problems, expenses related to natural disasters, or revenue from one-time projects.

2. Compensation Adjustments

Shareholder and management compensation is frequently normalized due to its discretionary nature. Some business owners may pay themselves what they can afford, rather that the market rate of the services they perform. In other cases, a business may pay the owner more than the fair market value rate for someone performing the same services. An adjustment is therefore necessary to reflect the true economic benefit available to the company.

Valuators also may consider whether salary amounts paid to shareholders or family members are driven by tax planning purposes.

There may also be discretionary or personal expenses such as golf dues, personal use of automobiles and cell phones that need to be considered.

3. Adjustments for Non-arm’s Length Transactions

Valuators must consider related party transactions such as rent paid that is either above or below market rates.

4. Redundant Asset Adjustments

Redundant assets and liabilities are those that are not essential to the normal operations of a business. As a result, any income or expenses associated with redundant assets may be adjusted. An example of a potential redundant asset includes marketable securities. Assuming, the company does not operate in the marketable securities industry, any income may be removed as it’s not essential to the operations of the business. For other examples and a more in depth understanding of redundant assets and liabilities, please see our Redundant Assets blog.

In summary, it is important to remember that value is based on prospective earnings, and that the objective of the adjustments is to estimate levels of maintainable earnings in the future. As mentioned, there is no precise formula or handbook to guide a Valuator in making the adjustments necessary. It requires good judgement and experience.

If you need help navigating the complicated areas of business valuation, the experts at Davis Martindale can help you. Give us a call today for a personalized discussion.