A business valuation is usually concerned with more than what the business earned in its most recent financial year. The more important question is often what level of earnings the business can reasonably be expected to continue producing. This is where maintainable earnings become important. A business may report a strong profit in one year, but if that result was driven by a one-off contract or unusual event, it may not represent the true ongoing earning capacity of the business. Likewise, a weaker year may contain one-off expenses that make the underlying performance appear worse than it really is.
Last year’s profit is not always the right starting point
Imagine a business that normally generates similar profits each year, but its most recent result was unusually high because of a large one-off project. Simply valuing the business based on that exceptional year could overstate its underlying earning capacity. The opposite can also happen if a business incurs an unusual expense that significantly reduces profit even though that cost is unlikely to occur again. A valuation therefore needs to distinguish between normal business performance and unusual events that may distort the result.
Normalisation helps show the underlying business
The financial statements of privately owned businesses often contain items that require further consideration. Some expenses may relate specifically to the current owner, while others may be genuinely non-recurring. There may also be unusual income that should not be assumed to continue. Adjusting for these items can help establish a clearer picture of the underlying earnings available to a future owner. This process is often referred to as normalising the earnings, and it can have a significant influence on the valuation outcome.
Not every expense is an add-back
An expense does not become an add-back simply because an owner would prefer it excluded from the valuation. If a cost will still be required to operate the business after ownership changes, it generally needs to remain part of the assessment. For example, if the owner currently performs a full-time operational role, a buyer may need to employ someone to undertake that work. The cost of replacing that labour may need to be considered when determining maintainable earnings. The objective is accuracy, not simply producing the highest possible earnings figure.
Trends also matter
A valuer may also consider whether earnings are increasing, stable or declining. Three years of consistent earnings can provide a very different picture from a business whose profits have fallen materially each year. Strong recent growth may also require examination to determine whether it is sustainable or whether it was driven by temporary circumstances. Historical results provide evidence, but valuation involves considering what those results suggest about the future rather than simply averaging numbers without context.
When a valuation methodology applies a multiple to maintainable earnings, even relatively small changes to the earnings figure can materially influence the resulting valuation. That is why this part of the process deserves careful attention. Before asking what multiple should apply to a business, it is worth establishing exactly what earnings figure that multiple should be applied to. A valuation is only as useful as the assumptions underneath it.
If you want to know more feel free to reach out. Contact us for personalised assistance and expert guidance.
Regards,
Tony Arena