There are a multitude of valuation methods, all of which are unique in their own way. However, they do have one thing in common: the value of any business comes from its ability to generate future earnings.
The appraiser typically begins the valuation process by measuring a company’s earning power reflected in the historical financial statements. However, the appraiser needs to review the financial statements in detail to ensure that the value of assets and liabilities are properly reflected on the balance sheet and that the income statement is adjusted to exclude non-recurring or unusual items which can distort a company’s earning potential. Examples of these adjustments include items such as undervalued/overstated assets, excessive compensation to family members and owners, one-time legal expenses, excessive travel and entertainment expenses. Once identified, the valuation expert then adjusts the company’s financial statements to reflect financial performance under “normal” operating conditions.
How does the valuation expert define “normal”?
When reviewing the financial statements, the appraiser must “normalize” the carrying value of assets reflected on the balance sheet as well as the earnings reflected in the income statement.
In many cases, the appraiser will adjust the assets and liabilities on the balance sheet to more appropriately represent their fair market value or some other standard of value appropriate for the valuation. One example of these adjustments involves the use of accelerated depreciation. When an asset is depreciated at an accelerated rate, it distorts the true value of that asset, typically showing the asset worth less than its actual value on the balance sheet. If the asset is fully depreciated over a five-year period, but the useful life of that asset is 10 years, an adjustment must be made to the balance sheet to increase the value of that asset to represent its true value as of the date of the valuation.
Normalization adjustments on the income statement help reflect a more accurate level of earnings and cash flow produced by operations. Some common income statement adjustments include:
Owner compensation – It’s not uncommon to find business owners paying themselves salaries above what might by typically paid to a third party for a similar service. If this is found to be true, the additional compensation paid that is over and above a market-based compensation must be added back to reflect the cash flow a hypothetical buyer would have available to them.
Accounting methods – There are many legal accounting methods that can be used to manipulate the profitability that a business reports at the end of the year. One such method is the last-in, first-out (LIFO) method of accounting for inventory. In a market where prices are increasing, the business will count the cost of the most recently purchased inventory (last-in) against the sales price (first-out). This will result in the company showing less profit than if the lower cost inventory were sold at the same sales price. An appraiser might find it necessary to adjust the financial statements to reflect first-in, first-out (FIFO) inventory accounting to provide a more accurate valuation.
Nonrecurring events – When estimating ongoing cash flow available to a buyer, income or expenses that are determined to be “one time” or nonrecurring must be removed. One example of this would be to remove a historical judgment in the form of a settlement paid or received by the business. This is not income received or an expense incurred in the normal course of business. However, if this cost is a normal course of business and can be accurately projected, the adjustment might not be appropriate.
How does a valuation expert determine if a “normalization” adjustment is appropriate?
Whether a normalization adjustment is appropriate depends upon the purpose of the valuation. In the case where a minority interest is being valued, the minority owner does not have the ability to change the discretionary practices within the company. The appraiser needs to evaluate each adjustment to determine the impact on the valuation. It is unlikely that the majority owner will adjust compensation so excess compensation would not be adjusted. However, nonrecurring income or expenses would likely continue to be adjusted.
In circumstances where a majority interest is being valued for sale, adjustments will likely be made to reflect the profitability the company can yield if operated at a market level. Additionally, it is important to understand how your state recommends handling adjustments in situations such as divorce.
Why you need an experienced valuation expert
Failure to understand and implement normalization adjustments can lead to a valuation that overstates or understates the value. A well-experienced valuation professional is equipped to identify appropriate adjustments and help determine how to incorporate them into the calculation. Windham Brannon’s team of valuation experts is ready to assist you with your valuation needs. For more information, reach out to your advisor or contact Matt Stelzman.
