There are several questions that come to mind when we start talking about normalising earnings in a business valuation. Questions like; what role does the normalisation of earnings play in a valuation? Why is it necessary? How should it be approached? What are the typical adjustments? Let us delve deeper.
The concept of normalised earnings becomes relevant to businesses with established profitability. Such a business can be valued by either using the market approach, in which case the normalised earnings becomes the basis to which earnings multiples are applied, or valued using the discounted cash flow (‘DCF’) method where the normalised earnings becomes the basis from which the future free cash flows are forecasted.
It is important to normalise earnings so that businesses being valued are done so on sustainable profits or cash flows being generated. These profits or cash flows also need to be relevant and comparable to the historical results and in order prevent the skewing of results when calculating implied earnings multiples.
The normalisation of earnings is applied to the last historic year, on which the forecast would then be based. This allows a hypothetical or potential acquirer to see what the return profile of the business would be post the valuation date and if this will be based on sustainable profits or cash flows. Furthermore, in the event of an acquisition, any earn-outs based on a profit warranty need to be realistic in order not to penalise the seller and should be based on normalised earnings.
The normalised earnings is determined by ascertaining the abnormal or non-recurring revenues or expenses and then to adjust the earnings profile of the last year to reverse the effects of the abnormal or non-recurring events.
There are several adjustments that could be made to normalise earnings. Once-off revenues and projects that are abnormally large or of a special nature, insurance claims received, windfalls and non-business related expenses are examples where normalisation adjustments are needed. Restructuring costs of businesses going through change or non-market related salaries in small businesses and professional practices should also be adjusted to normalise earnings.
After adjusting earnings for the last historical year, it is a good idea to do a sanity check. This can be done by comparing it to the earnings profile in a normal trading year or for owner managed businesses this could mean considering what the earnings profile might look like in a corporate environment.
A major benefit in the process of normalising earnings is that it gives shareholders the opportunity to assess variation from a sustainable and efficiently managed business, highlighting changes that can be made to achieve a business operating closer to its fuller potential.
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