A recent post stated that business value is a function of three things, expected cash flows, their growth, and the risks associated with their future receipt. This video (and text) post focuses on the first element, or cash flow. What adjustments are necessary to appropriately value a company? We normalize for non-recurring and unusual items and for discretionary expenses of owners. These are necessary to achieve marketable minority/financial control value. Then, if strategic control is desired, we adjust cash flows for synergistic or strategic cash flow benefits. It is important to understand the critical differences between normalizing and control adjustments.

Hello, Chris Mercer here at ChrisMercer.net and MercerCapital.com.

We’ll talk today about income statement adjustments.

A couple of post ago, I talked about the three key elements of any business value: that is the expected future cash flows attributable to the business, the growth of those cash flows, and the discount rate with which those cash flows are discounted to the present to achieve value today. Today, I want to talk about the cash flow itself, and what we have to do to get an appropriate cash flow to determine a business valuation. To do that, we’ll talk about what I’ll refer to as income statement adjustments.

There are two kinds of income statement adjustments – normalizing adjustments and then control adjustments. We’ll talk about these, but first let’s point out why it’s so important. The cash flow that we talked about in the previous post pertains to a particular level of value – that is the marketable minority or the financial control level of value. So if we have a different cash flow, we have a different value.

If we want to get to the appropriate level of value for our base value, then we have to get the appropriate level of cash flow. Well, what is that? It’s the as-if-publicly-traded, or the marketable minority value, which, as we talked earlier and as we’ll talk more in the future, is synonymous with the financial control value. So we look at an income statement, and what kinds of things do we do?

What are we looking for? Well, we’re looking for normalizing adjustments. In other words, we’re going to normalize the financial statements to a public-equivalent basis. Does that mean that the company has to be public? No, of course not, but that’s the ideal that we’re looking for.

Normalizing adjustments are for non-recurring, or unusual items of income or expense, or income or expense of non-operating items. That’s the first kind.

The second kind is what I refer to as discretionary or agency expenses. In other words, the expenses of owners that are well in excess of what would be incurred in a well-run publicly traded company.

So, non-recurring and discretionary and agency expenses. Some appraisers will say those are control adjustments – because the minority shareholder can’t control. Well, the minority shareholder over here can control because he can sell the stock and leave the company. So that is not really an argument for not making compensation-related adjustments in valuation. That’s well spelled-out in my book, the Second Edition of the Integrated Theory. Travis Harms and I have the Third Edition coming out, hopefully later this year.

The second kind of adjustments are what I call “control adjustments,” and these adjustments relate the income statement to the financial control buyer or to the strategic control buyer on the levels of value chart. The financial control adjustments might be those adjustments that a buyer would make and share in valuation with a seller. They are typically quite minimal, because the marketable minority value and the financial control value are fairly synonymous. In other words, the cash flow to the marketable minority and cash flow at financial control levels are generally speaking the same.

What about the strategic control level? Well, we need cash flow strategic and those adjustments are the kinds of synergistic or strategic adjustments that buyers of companies that have strategic or synergistic intent might make. And that would be, I’m going to reduce expenses substantially, or I’m going to sell into a new markets – things of that nature. And those strategic or control adjustments create a strategic control premium.

But the result, the cause of the strategic control premium, is not something magical. It’s the cash flow adjustment.

Now, there’s a publication out called the Measurement and Application of Market Participant Acquisition Premiums published by The Appraisal Foundation. The working group there equated what’s called a “market participant acquisition premium” and the strategic control premium as the result of those cash flows from these control adjustments.

So you see, if we want to value a company – if you want to understand the value of your company – you have to make appropriate normalizing or if your objective is strategic control, control adjustments.

I hope this is helpful! Good day.