Both business appraisers and market participants who buy or sell companies typically consider a number of adjustments to a company’s income statement in their valuation processes.  These adjustments are called normalizing adjustment, because they take reported financial statements and make adjustments to see what “normal” earnings look like.

Two Categories of Normalizing Adjustments

There are two broad categories of potential normalizing adjustments.

1. One-time adjustments.  These one-time adjustments are made to reflect one-time items of expense or income that hit in a particular period.  These items might be single events (such as a litigation settlement) that hit income or expense, but are not part of normal operating expenses.  One-time adjustments are also made to reflect other unusual or non-recurring events.  For example, there could be a one-time write-down of inventory that flowed through cost of goods sold.  The inventory is gone and the write-down will not recur.  There are a variety of similar or related one-time expenses that might be considered by a business appraiser or a market participant.
2. Discretionary adjustments.  Discretionary expenses often relate to excess owner compensation relative to market pay for similar jobs. For example, an owner might pay herself $500 thousand per year, when a good substitute manager is available in the marketplace for $250,000.  The difference, or $250,000, would be added back to normalize earnings.  The catch is that if the company is sold, the owner’s personal compensation would be reduced to $250,000 because she got the benefit of the normalizing adjustment in the valuation through higher company earnings. Compensation adjustments can work in reverse.  If our owner paid herself $200,000 per year, the adjustment would be to reduce adjusted earnings by $50,000 to account for normal compensation expense.  Discretionary expenses associated with owner-related nonoperating assets might be similarly adjusted.  Another example of a discretionary expense might be in charitable contributions made through a business.  If a business owner made a $1 million charitable contribution out of company earnings, there would be a normalizing adjustment in the appraisal for this amount.

All this seems simple enough, but the process of normalizing earnings requires a good bit of judgment on the part of appraisers and particularly on the part of buyers of businesses.  Sellers often desire to normalize everything, or practically so.  At a given multiple of earnings, an additional dollar of normalized earnings produces perhaps $5 or more of incremental value for the business.  Sellers tend to be optimistic.  Buyers tend to be skeptical.  Business appraisers need to be careful.

Recurring or Not?

I’ve seen business appraisals where the appraisers made many adjustments in each year of the analysis.  The problem with this is that what may, on the one hand, seem to be unusual or non-recurring, may not be so.  There is a randomness to business, such that one year’s potential non-recurring item is offset by another of a similar amount the next year, and so on.

One way that appraisers and buyers check on the reasonableness of proposed normalizing adjustments is by checking the implied earnings margins that result from the adjustments.  For example, I have seen an appraisal in which the appraiser “normalized” earnings to substantial double-digit EBITDA margins for a fairly typical company in an 8% to 10% EBITDA margin industry.  The result of the normalization process was simply not believable.

I’ve often said that business life is full of one non-recurring event after another.  Normalizing adjustments are important tools for business appraisers and for business buyers.  Your business appraiser will likely not adjust for everything you might think is non-recurring and your potential buyers almost certainly will not make all the adjustments.  There is a natural tension that is balanced by the history of the business and its history of and expected margin structure.

Questions?

Look around this blog.  I’m addressing many questions that business owners have asked and many more questions that I’ve heard about or observed.  My answers will not be technical, but hopefully explanatory and illustrative of important business valuation concepts.  If you have a question, comment on this post, email me (mercerc@mercercapital.com), or call me (901-685-2120).

If you really want a deep dive on normalizing adjustments, and their sister adjustments, called control adjustments, take a look at Chapter 4 of my book Business Valuation: An Integrated Theory Second Edition.  If not, we’ve covered the gist of these adjustments for sure.

If you know you need a business valuation and would like to receive a complimentary proposal, click here or call me at 901-685-2120.

If you would like to talk to me about your business and its value, about a transaction you are considering, or about any thorny management or ownership transition issues in a complimentary initial phone session, call 901-685-2120 and ask for Todd Lowe, my executive assistant.  He’ll schedule a workable time for us, or, if serendipity strikes, we’ll talk when you call.

For additional perspective on the implications of normalization adjustments, see these posts on identifiable earnings and transferable business value.

Until next time,

Chris