In our prior article, we started to address what adjustments we need to make to a firms earnings so that we can more reliably predict future cash flows. These are key to building a reliable DCF valuation. Last week we discussed how to adjust for non-market related owner’s compensation and discretionary expenses. This week we’ll look at how to treat one-time losses/gains, periodic expenses, and non-operating expenses.
Dealing with once-off losses or gains:
Once-off expenses or gains are reported below the Net Income line of the Income statement. They most commonly occur because part of the operations of the business have been discontinued – typically a product line, a regional branch, or a manufacturing process. It’s very easy to deal with the impact of this if it happened in the current year – simply remove its impact from Profit Before Tax and re-calculate accordingly. However, most often we are looking at the last 3-5 years of financial statements and we may find such once-offs in years 2 and 4, for example. Since what we are trying to do is build a reliable history of the firm (to improve our predictions of its future growth potential), we need to add back those once-off losses (or subtract such gains) to the Profit Before Tax number for each year and recalculate our Net profit accordingly. The skill comes when trying to estimate how much profit (or loss) should be applied to the years before the actual adjustment, since in each of these years there has been expenses or income from these discontinued operations mixed amongst the recurring business. The shortcut here is that if the once-off gain/loss was less than 10% of the profit for a year and if it happened 3 or more years ago, then you can fairly safely ignore it and focus on the more recent years instead. If the adjustment is in the current financials, then its much harder to put much certainty on future earnings. Dig deep to understand the likely impact.
Most expenses in a business happen more or less predictably each year. Yet ever so-often there are major expenses associated with something that doesn’t happen every year, isn’t always predictable, but does happen and is a major expense or disruption. Know any of these? The most common one I see is moving expenses. Having gone through several office moves myself these not only incur costs (and emotional debate about choices of finishes and parking allocations) but also impact sales and productivity, sometimes for a while. If you’re buying a business its location is often a major part of the deal: some businesses are bought purely for the value their location brings, in others, moving the business 1 block away could make or break it. The key thing to understand is when the business is next likely to move (or incur any other periodic expense) and to provide for the impact this would have. As a hint, look at the terms of the lease to get a feel for how soon this would happen. If you are unsure, then take a reasonable estimate and provide for it in each of the next 3-5 years. The other classic periodic expense is legal action – most companies face legal action from trading parties, former employees or customers sooner or later. Their unpredictability and importance means that the sellers often indemnify the buyers of a business from legal action as part of the sale agreement.
These are more complex. Years ago a business where I worked leased a house in a popular holiday spot and reflected this on the books as a ‘conference venue’. It was merely a perk for staff and some clients who made use of it, and wasn’t integral to the business – a classic non-operating expense. The local example I come across regularly is the ‘box’ at the local sports stadium – these are primarily used for entertaining clients and become an on-going non-operating expense that needs to stay in the books. In general, non-operating expenses are a region of adjustments where you need external advice, especially if anything is big and chunky or requires long-term renewal shortly after you intend doing a deal.
By now, I hope you’re getting the picture as to why it’s important to go through the firms’ existing and historic statements and the types of adjustments we need to make before we can determine the realistic picture going forward. In next weeks’ article we will wrap up this section with a worked example (the published notes will be supplemented with a downloadable Excel spreadsheet).
This article originally appeared in Finweek.