Understanding Valuation Earnings Adjustments
Understanding Valuation Earnings Adjustments
In this blog, we discuss how valuation earnings adjustments can have a material impact on value and why they are a key consideration in the valuation process.
When it comes to valuations, getting to the bottom line is easier said than done. Valuators must navigate their way through a financial road map. This requires an understanding of the adjustments needed in order to provide an accurate picture on future earnings.
In this blog, we discuss valuation earnings adjustments and their importance to the valuation process.
We will begin by considering the following details about adjustments:
- What are common adjustments?
- How are they determined?
- Can they have a material impact on value?
And perhaps the most important question, why are adjustments a key consideration in the valuation process?
Before we get there, it’s important to recognize that valuations are prepared on the notion that value is prospective. That means the value of a business, or an asset is based on the returns one anticipates could be generated in the future. Since there’s no crystal ball to predict future performance, valuators often look at past performance as an indicator of future earnings.
Let’s Talk Adjustments
Adjustments can have a material impact on value. So how are adjustments determined?
There is no precise formula used to determine the range of normalized earnings. Quantitative and qualitative analysis is often required to identify major historical trends. While there’s 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 a thorough examination of a company’s historical earnings.
This requires a look at a period of years before the valuation date. Ideally, a review of a complete business cycle lays the foundation for analysis and projections. It’s important to consider 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 while adjustments may be determined through discussions with shareholders and management.
The goal of the analysis is 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. They 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.
Other examples of non-recurring costs or revenue include:
- Discontinued operations,
- Lawsuit settlements,
- Start-up costs,
- Moving costs,
- Labour problems,
- Expenses related to natural disasters,
- 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 than by the market rate for 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/or cell phones that need to be considered.
3. Adjustments for Non-arm’s Length Transactions
Valuators consider related party transactions and whether these transactions are above, at, or below market rates. For example, if a company rents a building from a related party, they may or may not pay the same amount of rent to the related party as they would to a third party. Valuators will adjust related party transactions to market rates as a notional buyer would pay 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.
For example, marketable securities are a potential redundant asset. Assuming the company does not operate in the marketable securities industry, any income from the marketable securities should 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.
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