The art of normalization in business valuation
INSIGHT ARTICLE |
Under the discounted cash flow method, the enterprise value of a firm is calculated as equal to the sum of its expected future unlevered free cash flows, discounted to present value using arisk-adjusted discount rate. Application of the discounted cash flow method can therefore be thought of as requiring three steps: (1) the projection of earnings and related cash flows over a discrete, finite projection period, perhaps five years, and for the year immediately following, which is used to calculate a terminal value; (2) an estimate of the expected rate(s) at which the firm’s earnings and cash flows will grow over the periods projected; and (3) the estimation of a risk-adjusted discount rate.
Steps (1) and (2) are inextricably related in that the analysis and estimation of a firm’s growth over the finite projection period and in the period used to calculate a terminal value requires the identification and measurement of the base-level earnings and cash flows that it is expected to generate on a recurring basis. For instance, the effect on earnings and cash flow from items such as gains on restructurings or asset sales, or losses attributable to the costs of environmental remediation or recovering from a natural disaster, might not be expected to repeat in the future. In contrast, earnings that can be expected to repeat and grow in the future are referred to as sustainable earnings (aka core, persistent or underlying earnings). By extension, the calculation of the value of a controlling interest in a firm also begins with a determination of the subject firm’s sustainable earnings and cash flows, but with adjustments to account for the ownership characteristics of the interest. The process used to identify sustainable earnings as well as adjustments necessary to account for the characteristics of a controlling ownership interest is referred to as normalization.
Identifying sustainable earnings
Viewed from the prism of sustainable earnings and cash flows, revenues, costs, gains and losses that are not expected to repeat prospectively on a recurring basis are referred to as transitory or unusual items. Consequently, the analysis of growth requires that transitory or unusual items be identified and removed from reported operating income, which can be thought of as equal to the sum of operating income from sales, other operating income, and transitory or unusual items. The process is known as normalizing earnings for the reason that it is used to determine “normally” recurring earnings excluding the effect of transitory or unusual items.
The footnotes and management discussion and analysis (MD&A) portions of a firm’s financial statements are a good place to start in looking for transitory and unusual items. Per the U.S. Securities and Exchange Commission, the purpose of the MD&A section is to “describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of income from continuing operations and, in each case, indicate the extent to which income was so affected.” In addition, the MD&A section frequently provides information indicating how the operations of the business may change in the future. And while a firm’s income statement will report items deemed to be extraordinary explicitly, unusual items might also be found imbedded in gross margin through comparison of associated changes. To determine whether an item reported on a firm’s income statement is transitory or unusual also requires an understanding of the firm’s industry, business model and strategy. In some businesses, research and development costs incurred for a special project might be considered one-time, while for the semiconductor, software or pharmaceutical sectors, for example, such expenditures would likely be considered part of an ongoing program. Similarly, for a manufacturing business in the mature stage of the life cycle, startup costs for a new line of business could be classified as one-time, while for a high-growth retailer expanding in multiple locations, such costs might be expected to recur. The same reasoning holds for marketing expenditures, certain of which may be one-time and transitory depending on the underlying facts and circumstances. A firm dependent on brand-name recognition, however, may spend significantly on marketing and advertising on a recurring basis.
Gains and losses that appear normally in each period but which are random and therefore not predictable should also be considered unusual as their expected value over time is zero. Examples include gains and losses from foreign currencies and derivatives trading, as well as items that result from mark-to market accounting. A nonexhaustive list of unusual items would include special charges and liability accruals, one-time and extraordinary items, asset write-downs, startup costs, gains and losses from asset sales, restructuring charges, profits andlosses from discontinued operations, the effects of accounting changes, unrealized gains and losses on equity investments, and gains on share issues in subsidiaries.
Deferred revenue —In accordance with generally accepted accounting principles (GAAP), firms recognize revenue when merchandise is delivered or services are provided. So for amultiyear sales contract for computer hardware or software and related services, education, consulting, maintenance and upgrades, the upfront cash payment is recognized on the balance sheet and cash flow statement, while the revenue for the contract is initially accounted for as a deferred revenue liability until the time the subject services are provided (deferred revenues simply represent advance payments of cash). The amount of revenue to be deferred, however, is based on an estimate, which can result in too much revenue being recorded in the current period, or too much being deferred to the future. The latter case is more prevalent, with firms treating deferred revenue as a “cookie jar,” and bleeding it back to the income statement in the future to give the appearance of earnings growth. Earnings growth dependent on significant “bleedback” may not be sustainable, however. Further, there is no effect on cash flow since the related cash payment was recognized at the same time the deferred
revenue liability was established.
Restructuring, asset impairment and special charges —These are often appropriately considered to be one-time and unusual. For a firm restructuring its business over a period of years due to factors such as changes in technology, competition, demand or financial distress, however, such charges may be recurring. In the case ofEastman Kodak, which ultimately filed for bankruptcy in 2012, restructuring charges averaged $462 million per year between 2001 and 2008, or roughly equal to 4 percent of Kodak’s revenues and twice that of its capital expenditures.
It is also useful to understand what portion of a restructuring charge is cash, whether the cash portion will continue in the future and over what period. Firms typically charge an estimate of restructuring costs to income, while recognizing a corresponding restructuring reserve liability of equal amount.
The restructuring reserve liability is then reduced in the future by the amount of the actual cash restructuring costs spent. If the amount of the estimated charge exceeds the actual amount of future cash expenditures, the excess is bled back to income, creating earnings that may not be sustainable, and as with deferred revenue, having no effect on cash. The effect on earnings of asset impairment charges may also be one-time and unusual or recurring. Write-downs of fixed assets will reduce depreciation expense in the future, while inventory write-downs will lower cost of goods sold. Both are noncash charges with no effect on cash flow in the period taken. Future earnings will increase in both cases, however. The question is then for how long.
Research, development, marketing, advertising —For a firm competing in a product market characterized by rapidly changing technologies, cutbacks in research and development expenditures may increase current earnings to the detriment of future earnings. The same is true where a consumer products firm dependent on maintaining brand name recognition decreases its marketing and advertising expenditures. In both cases, it is necessary to analyze whether the effects of the reductions on costs are transitory or permanent.
Pension expense —A firm’s costs of providing defined pension plan benefits are accounted for in aggregate as pension expense and reported as part of its operating expenses. Pension expense can be broken down further into six components: (1) service cost, (2) interest cost, (3) expected return on plan assets, (4) amortization of prior service
cost, (5) amortization of transition asset or liability, and (6) actuarial gains and losses. Both service cost and interest cost are costs that recur, as are the amortizations of prior service cost and of the transition asset or liability. The same is true for actuarial gains and losses. Earnings that a firm realizes from the expected return on its plan assets are not earnings from the core business of the firm, however. Rather, they are a function of the profitably of the pension plan and as such should be disaggregated.
Changes in estimates —Some of the expenses found in a firm’s income statement, including warranty, bad debt and depreciation expense, are accounting estimates. In the event an estimate for a prior year turns out to be incorrect, the error is corrected in the current year. Consequently, in order to accurately measure current-year operations, changes in accounting estimates should be treated as unusual provided that sufficient data and information are available to make the adjustment. Note also that warranty, bad ebt and depreciation expense are noncash items.
Realized gains and losses —These can have a significant effect on reported earnings. Most often, however, they are reported not in the firm’s income statement but in the footnotes or in the cash flow statement as a reconciling item between cash flow from operations and net income. While for an investment management firm, realized gains and losses would be an element of core income, for other types of firms they would be unusual.
Unrealized gains and losses — Unrealized gains and losses on equity securities can arise from interests of less than 20 percent that are marked-to-market. Since changes in the market value of equity securities do not serve to predict future changes in their market value, however, unrealized gains and losses (on paper as opposed to cash) on equity securities should be regarded as transitory. Unrealized gains and losses that result from the application of fair value accounting to assets and liabilities should also be considered transitory except where they offset an element of core operating income.
Terminal value specifics
In a discounted cash flow analysis of a going concern, the present value of the cash flows expected to be generated by the firm in perpetuity subsequent to the finite forecast period is measured by the terminal value (aka residual, horizon or continuing value). While based on a capitalization of one year’s earnings and cash flow and consequently lacking the yearby-year detail provided for each period of the finite forecast, the terminal value calculation is nevertheless critical in that it often represents 50 percent or more of a firm’s total value, particularly in the case of a startup or early-stage company. Consequently, where the constant-growth perpetuity model (i.e., VF, t = FCF t + 1 /( rWACC - g ), where VF, t = the value of the firm at time t; FCF t + 1 = free cash flow to the firm at time t + 1; rWACC = the firm’s weighted average cost of capital; and g= the expected long-term growth rate) is used to measure the terminal value, the base-year cash flows must be normalized to ensure that the levels of investment, profitability and rate of return are adequate for the cash flows to grow at the perpetual growth rate assumed in the model (by way of background, note that the majority of value in a perpetuity calculation is captured mathematically in the first 25 years despite the going-concern assumption that the firm will continue to operate indefinitely). Underlying the use of the constant-growth model is the assumption that the subject company has reached a steady state. This assumes that the base period free cash flow is positive and growing at a constant rate in perpetuity, and that the firm’s discount rate, capital structure, operating risks, and required and expected rates of return are constant. In practice, revenues and free cash flows are assumed to grow at the same rate in perpetuity as of the terminal value date. In this regard, while the individual items that go into the calculation of free cash flow do not have to grow at that same rate, the effect of changes in one component must be compensated for by that in another.
In transitioning from the finite forecast period to the terminal value, it is also important to recognize that when the revenue growth rate decreases from a high to a constant rate, the growth rate for free cash flows may be greater than that for revenue if the growth rate for capital expenditures and increase in working capital investment (both reduce free cash flow) are less than the constant revenue growth rate. If so, it may be necessary to extend the period over which the firm’s yearby-year detailed forecasts are modeled until the long-term constant growth rate for revenues is equal to that of free cash flow. Otherwise the terminal value, and in turn, value of the firm, may be understated.
The growth in base-year capital expenditures, depreciation and the relationship between the two should also be appropriate for the assumed constant growth rate. Beyond this general principle, assuming that the firm uses straightline depreciation and that the economic and useful lives of its assets are equal, the relationship between capital expenditures and depreciation will mainly be affected by changes in inflation, productivity and the expected real rate of growth during the terminal value period. To illustrate, assuming a steady state and no change in productivity, no real growth or lump capital expenditures, capital expenditures might equal depreciation if inflation has remained constant, while they may exceed depreciation if inflation has increased, or be lower if inflation has decreased.
Controlling ownership interests
Control can be thought of as the right to direct strategy and operations, make resource allocation decisions and distribute the cash flows generated by a firm. Examples include the ability to determine compensation, approve contracts, pay dividends, register stock for an initial public offering, authorize share repurchases, undertake mergers and acquisitions, approve capital expenditures, revise the articles of incorporation, and establish strategy. The increment that an acquirer pays over the market price of a company to achieve a control level of value is referred to as a control premium.
The characteristics of an ownership interest can generally be described by four levels of value (see chart below). Strategic value equals the value of the firm plus control plus synergies, while financial control value equals the value of the firm plus the value of improvements or changes to its existing operations from being run more efficiently or differently. Marketable, minority interest is then the value of publicly traded shares that lack control but are readily liquidated, while nonmarketable, minority interest refers to the value of shares in a privately held firm that lack control and are not easily sold.
As when valuing a firm, in valuing an ownership interest it is necessary to first identify normally recurring base level earnings excluding the effect of transitory or unusual items, and to normalize terminal value base-year cash flows. The characteristics of the interest should then be analyzed to evaluate whether it is controlling or minority. If controlling and appropriate given the facts and circumstances, the cash flows should be normalized to eliminate excess compensation, perquisites, discretionary expenses and operating inefficiencies, delete or adjust related-party salaries, benefits or out-ofmarket contracts, and institute changes in capital structure. The failure to do so can lead to a significant understatement of value.