There are many valuation approaches and methods, but they all have one thing in common: Ultimately, the value of a business is derived from its ability to generate earnings in the future.
Typically, the starting point for measuring a company’s earning power is its financial statements and other documents that reflect historic financial performance. But often, these documents contain entries — such as above-market owner compensation or nonrecurring expenses or income — that can distort a company’s true earning potential. For this reason, valuation experts often adjust a company’s financial statements to provide a picture of its financial performance under “normal” conditions. This serves two purposes: to remove “owner bias” from the financial statements, and to derive unbiased financial statements for valuation purposes.
A valuation expert might normalize a company’s balance sheet by adjusting its assets and liabilities to fair market value or some other appropriate standard. A business, for example, might have used accelerated depreciation methods that distort the values of certain assets. If the company has fully depreciated a piece of equipment over five years, but its actual useful life is 10 years, a normalization adjustment may be necessary to reflect the asset’s true value. What’s the rationale behind this? Adjusted depreciation expense reflects a truer picture of economic reality.
On the income statement, normalization adjustments may be appropriate to develop a more accurate earnings history. Common areas for adjustment include:
Owner compensation. It’s not unusual for business owners to pay themselves above-market salaries and benefits for services they provide to the company. Adjusting owner compensation to reflect market rates for comparable positions provides a more accurate measure of value to a hypothetical buyer of the business.
Accounting methods. Businesses select accounting methods for a variety of reasons — including tax planning — that don’t necessarily reflect their actual financial performance. For example, many companies elect the last-in, first-out (LIFO) method of accounting for inventory because it can yield significant tax benefits. But the method can also understate a company’s inventory and depress its earnings. A valuator might adjust the financial statements to reflect first-in, first-out (FIFO) inventory accounting to provide a more accurate valuation.
Nonrecurring events. “One time” income or expense items can distort earnings. So, in order to more accurately reflect a company’s future potential, a valuator might eliminate from historical earnings a judgment or settlement paid or received by the business or a significant bad-debt expense. Of course, for some businesses, bad debts and litigation expenses are a “normal” part of doing business, so in that case an adjustment wouldn’t be appropriate.
What’s the purpose?
Whether a normalization adjustment is appropriate may depend on the valuation’s purpose. If a minority interest in a business is being valued, for example, a valuator probably wouldn’t adjust owner compensation, because a minority owner wouldn’t have the power to change this expense.
If a business is being valued for sale, on the other hand, it’s often appropriate to adjust compensation downward to reflect the salaries a buyer would likely pay. Similar adjustments might also be appropriate in a divorce context to ensure that the nonowner spouse is treated fairly. In addition, when valuing a business for sale, a valuator might adjust for synergistic benefits, such as economies of scale or for cost savings a buyer might enjoy after integrating the business into its own.
Failure to consider normalization adjustments — or making inappropriate adjustments — can lead to inaccurate valuations. Experienced valuation professionals are well equipped to identify normalization opportunities, determine whether adjustments are appropriate and incorporate them into their calculations.