Earnings Normalization and Cash Flow Estimation Issues

Earnings Normalization and Cash Flow Estimation Issues

Private company valuations may require adjustments to estimate the company's normalized earnings as their reported earnings reflect discretionary expenses. This results in differences between reported earnings and normalized earnings. Normalized earnings are economic benefits adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and facilitate comparisons.

Normalized earnings = Reported earnings + Adjustments (for nonrecurring, non-economic and unusual items)

Private companies' earnings are adjusted for numerous reasons:

  • The effect of transactions between the private company and the owners and/or their companies.
  • Above-market compensation or other expenses that reduce taxable income and income tax expense. Family members may also be included as employees.
  • For private companies with report losses, expenses may be understated with the reported income of the entity overstated.
  • Personal expenses may be included as expenses of the private company. The use of corporate vehicles for personal use may also require adjustments.
  • Loans to shareholders/top management merit review.
  • Real estate used by the private company requires review. When the private company owns real estate, some analysts may remove any revenue and expenses associated with the real estate from the income statement. The value of the real estate would represent a non-operating asset of the company. These adjustments are necessary because of business operations and real estate’s different risk and growth expectations.
  • The financial statements of private companies are reviewed rather than audited as is the case for public companies. Reviewed financial statements provide an opinion letter with representations and assurances by the reviewing accountant that are less than those in audited financial statements.

The private company may be incorrectly valued without these adjustments on reported financial performance.

Cash Flow Estimation Issues for Private Companies

Cash flow estimation for private companies raises important challenges like the nature of the interest being valued, potential uncertainties regarding future operations, and managerial involvement in forecasting.

The equity interest being appraised and the intended use of the appraisal are key in determining the appropriate definition of value for a specific valuation. Assumptions may differ when valuing a minority equity interest compared to the total equity of the business.

Many development-stage companies and some mature companies are subject to significant uncertainties regarding future operations and cash flows. A possible solution involves projecting the different possible future scenarios including initial public offering, acquisition, continued operation as a private company, or bankruptcy. The discount rate should reflect the risk of the projected cash flows in that scenario. The probability of the occurrence of each scenario must also be estimated. The overall value estimate for a company is the probability-weighted average of the company's estimated scenario values.

Managers of private companies have more information about the business than outsiders. When valuing using management's forecast, analysts should be aware of potential managerial biases, such as overstating values in the case of goodwill impairment testing, understating values in the case of incentive stock option grants, and capital needs.

The process for estimating FCFF and FCFE is similar for private and public companies.

$$\begin{align*}\text{FCFF}&=\text{Operating income after taxes}+\text{Depreciation and amortization}\\&-\text{Capital expedictures}-\text{Increase in working capital}\\ \text{FCFE}&=\text{FCFF}-\text{After-tax interest expense}+\text{Net borrowing}\end{align*}$$

FCFF is preferred when the company is expected to undergo significant capital changes because WACC is less sensitive than the cost of equity to changes in financial leverage.

Question

Which of the following is least likely a reason for adjusting a private company’s earnings when performing valuations?

  1. The effect of transactions between the company and its owners.
  2. Personal expenses of shareholders being paid by the company.
  3. Audited financial statements.

Solution

The correct is C. 

Audited financial statements are the least likely reason for adjusting a private company's earnings, as private companies are not required to provide audited financial statements. Their financial statements are reviewed.

A is incorrect. The effect of transactions between the company and its owners are items to consider when estimating a private company's normalized earnings as these are not expected to persist once the company is acquired.

B is incorrect. Personal expenses of shareholders being paid by the company need to be deducted from the company's earnings as these are not expected to persist into the future once the firm is acquired.

Reading 27: Private Company Valuation

LOS 27 (c) Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings.

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