Just because two businesses report the same numeric value for earnings, doesn’t mean they are of equal value. There is far more to earnings than may initially meet the eye. Just because two businesses have a similar sale price, it doesn’t mean that they are of equal value. We must dig deeper in order to truly understand the value of a business and look at the three key factors of earnings.
Key Factor # 1 – Quality of Earnings
It is essential to determine the quality of earnings. In determining the quality of earnings, you’ll want to figure out if earnings are padded. Padded earnings come in the form of a large amount of “add backs” and one-time events. These factors can greatly change earnings. For example, a one-time event, such as a real estate sale, can completely alter figures, producing earnings that are simply not accurate and don’t represent the actual earning potential of the company.
Another factor to consider is that it is not unusual for all kinds of companies to have some level of non-recurring expenses on an annual basis. These expenses can range from the write-down of inventory to the expenditure for a new roof to a lawsuit. It is your job to stay on guard against a business appraiser that restructures earnings without any allowances for extraordinary items.
Key Factor # 2 – Sustainability of Earnings After the Acquisition
Buyers are concerned about whether or not the business they are considering will continue to grow at the previous rate or if the company is at the apex of its business cycle. Just as professional sports teams must carefully weigh the signing of expensive free agents, attempting to determine if an athlete is past his or her prime, the same holds true for those looking to buy a new business.
Key Factor # 3 – Verification of Information
Buyers can still run into serious problems even after they carefully weigh quality and earnings and the sustainability of earnings after acquisition. A failure to verify information can be catastrophic. Buyers must verify that all information is accurate, timely and as unbiased as possible. Many questions need to be asked and answered, such as has the seller been honest, and has the company allowed for possible product returns or non-collectable receivables.
Buyers can dramatically reduce their chances of being surprised if they address these three key factors. Two businesses with very similar values may look essentially the same on paper, however, by digging deeper, it is possible to reach very different conclusions as to the value of the businesses in question.