Understanding Value Earnings Adjustments
Valuations tend to be more complicated and long-winded than you expect – creating an accurate picture of what future earnings will look like is easier said than done. While there are several methods to concluding a company’s value, most valuation analysts will look at past performance to predict the company’s future value.
To predict this as accurately as possible, they need to find what the company’s true earning capacity is. Therefore, a common step when carrying out a business valuation is to search for the value earning adjustments.
In this article, we will discuss what value earning adjustments are, common value earning adjustments, and how they impact the valuation process.
What are Value Earnings Adjustments?
Value earning adjustments are expenses that are either discretionary or don’t relate to the general operation of the business. These expenses don’t reflect the company’s true earning capacity, and adjustments are made to properly evaluate what a business can earn in the future without them.
There isn’t a strict formula that determines the true earnings to create an accurate valuation, but the most recognised way of doing so is by analysing the company’s earnings over a period of several years. And while it might not be an exact science, identifying adjustments can result in a more accurate estimation of what the company could earn in the future.
What are the Common Value Earnings Adjustments?
Firstly, let’s identify the two categories of earning adjustments. Broadly speaking, adjustments can be grouped into these expenses:
- Discretionary compensation expenses
- One-time expenses
However, there are some adjustments that don’t fall into these categories. One of them is redundant asset adjustments. Redundant assets are not related to the normal running of a business, so can be adjusted.
Not all adjustments can be applied in every valuation case. The purpose of the valuation tends to guide or determine what adjustments are reasonable and relevant.
Discretionary Compensation Expenses
Company owners tend to pay themselves and the leadership team what they can afford, not necessarily what the market rate is for their role. This can be above or below the market rate. In these cases, the valuator or analyst can make an adjustment by determining the market value level of salary/compensation for the role and adjusting financial statements accordingly.
For example, if Company A pays its owner £300,000 per year but the fair market value rate for the services rendered is £150,000, this would result in an adjustment of £150,000 to Company A’s financial statement.
- Ghost compensation
Many companies, particularly in the start- to- scale-up stages, will have employees on payroll that aren’t necessarily involved in the day-to-day operations of the business. This could be a family member who receives some kind of compensation from the company while not strictly being employed by them. In these cases, financial statements should be adjusted to account for the compensation of these ‘ghost’ employees.
- Further Discretionary/Personal Expenses
Business owners might expense the cost of personal items to their company. These aren’t operational expenses and have no impact on the operation of the company. Personal discretionary compensation expenses might include company cars, golf memberships, gym memberships, travel and meal expenses, and other expenses that are not related to the normal cost of running the company.
One-time expenses are self-explanatory: they’re non-recurring expenses that are not likely to happen again. They generally don’t relate to the company’s typical expenses or activities. Valuators or analysts might identify these adjustments by carrying out a trend analysis across multiple years prior to the valuation to determine what the company’s normal expenditure is.
Examples of one-time expenses include:
- Litigation settlements
- Consultant fees
- Revenue gains or losses from one-time sales
- Revenue gains or losses from discontinued products
- The tax implications of one-time sales or discontinued products
- Moving costs i.e. changing offices
- Expenses related to unusual disasters i.e. a flood, hurricane, robbery
The Benefit of Adjusting Value Earnings
There are several benefits to finding the value earning adjustments. Adjusting financial statements accordingly can increase the yearly income benefit stream significantly, meaning the business gets a higher valuation. It also gives business owner’s the opportunity to seriously consider their cash flow – whether their compensation is too high or if a second office is necessary.
And if a business owner is initiating a valuation to exit the company, they must clean up the financials. Many business owners will run a variety of personal expenses through the company’s money, and while these can be adjusted for the financial statements, they might embed a seed of doubt in a potential buyer’s mind.
Almost every valuation will involve searching for adjustments and adapting the financial statements accordingly. And they’ll also often involve comparing metrics with competitors and peers. However, there isn’t a lot of data about private companies and fundraising out there.
At Finerva, we’ve considered how public markets can provide that data to assess and value private companies. Take a look at our extensive valuation report: we’ve delved deep into valuation multiples by sector, from Autotech to Robotics & AI. For further information or advice on valuations, get in touch with our expert team today.