TWO TYPES OF INCOME STATEMENT ADJUSTMENTS
Having described the general nature of normalizing adjustments and control adjustments, we now turn to their proper application.
- With normalizing adjustments, we attempt to adjust private company earnings to a reasonably well run, public company equivalent basis. Normalizing adjustments can be further divided into two types to facilitate discussion and understanding. Normalizing adjustments are not control adjustments.
- Control adjustments modify normalized private company earnings to reflect 1) the operational improvements anticipated by the typical financial buyer; and 2) synergies or strategies of particular buyers. Control adjustments can also be divided into two types. We will discuss control adjustments in a subsequent post.
This nomenclature for income statement adjustments is fairly new. Many appraisers do not distinguish between normalizing and control adjustments or between types of normalizing and control adjustments. This failure by some appraisers to distinguish between two significantly different types of adjustments lends to confusion on the parts of users of valuation reports and courts.
The specific vocabulary presented in these posts facilitates understanding of income statement adjustments, and clarifies the nature of and reasons for income statement adjustments.
INCOME STATEMENT ADJUSTMENTS AND THE RELEVANT DISCOUNT RATE
The importance of distinguishing between types of income statement adjustments becomes apparent when we discuss the discount rates applicable to derived earnings. The discount rate or capitalization rate applied to a particular measure of earnings must be appropriate for that measure, whether net income, pre-tax income, debt free net income or another level of the income statement.
As suggested in a recent post, the CAPM/ACAPM (the Adjusted Capital Asset Pricing Model which I have written about since 1989 and which is discussed in Chapter 6 of Business Valuation: An Integrated Theory Second Edition) discount rate applies to either the net income or net cash flows of business enterprises (and relates to the nature — dividend discount — of the Gordon Model). The discount rate does not change with changes in distribution, or dividend-payout, policies.
There has also been considerable discussion in recent years regarding whether discounted cash flow valuation models yield minority interest or controlling interest indications of value. The two major schools of thought are as follows:
- The CAPM/ACAPM discount rate is applicable to the net income (or net cash flow) of a business enterprise, and therefore yields a marketable minority indication of value. As a result, control premiums are properly applied to value indications at this level to derive a controlling interest conclusion of value.
- Appraisers often make control adjustments in developing their projections for DCF methods. If the income stream is “control adjusted,” the resulting valuation indication is at the controlling interest level. As a result, no additional control premium is appropriate, and a minority interest discount might be applied to derive a marketable minority value indication.
Appraisers have debated these two viewpoints for years. Depending on the adjustments made, either approach might yield similar results. However, the issue has been a source of confusion, and the debate has found a forum in the Tax Court. A number of recent appraisals submitted to the court have been scrutinized over the very issue of whether a DCF model yields a minority interest or a controlling interest valuation.
Dr. Shannon P. Pratt and others, including myself, have suggested that in DCF methods, the value of control is generally developed by adjusting the numerator (the projected cash flows). The following quote from Pratt’s Cost of Capital, 1st Edition (pp. 127-128) illustrates the consensus:
The discount rate is meant to represent the underlying risk of a particular industry or line of business. There may be instances in which a majority shareholder can acquire a company and improve its cash flows, but that would not necessarily have an impact on the general risk level of the cash flows generated by that company.
In applying the income approach to valuation, adjustments for minority or controlling interest value should be made to the projected cash flows of the subject company instead of to the discount rate. Adjusting the expected cash flows better measures the potential impact a controlling party may have while not overstating or understating the actual risk associated with a particular line of business.
While the above quote is found in a chapter dealing with discount rates, note the suggestion that control adjustments would be made to the marketable minority level of cash flows. If such adjustments are made, the indicated value would exceed the marketable minority level, and reflect on the controlling interest levels on the conceptual chart.
Properly distinguishing between normalizing and control adjustments in the context of the integrated theory of business valuation should bring clarity to this issue.
NORMALIZING ADJUSTMENTS TO THE INCOME STATEMENT
Normalizing adjustments modify the income statement of a private company to reveal a “public equivalent” income stream. If such adjustments are not made, the resulting indication of value is something other than a marketable minority value. Resulting values would there or not be “as-if freely traded” (see below).
For appraisers using benchmark analysis to determine marketability discounts, this would be disastrous, since the restricted stock studies are based on freely traded (marketable minority) stock prices.
Note that, in creating a public equivalent for a private company, the subject company need not have all of the characteristics of potential IPO candidates. Another name given to the marketable minority level of value is “as-if freely traded.” This terminology emphasizes that earnings are being normalized to where they would be as if the company were public. The framework does not require that a company be public or even that it have the potential to become public.
A new vocabulary is needed to clarify the nature of normalizing income statement adjustments. As noted earlier, there are two types of normalizing adjustments. Being very original, we call them Type 1 and Type 2.
- Type 1 Normalizing Adjustments. These adjustments eliminate one-time gains or losses, other unusual items, discontinued business operations, expenses of non-operating assets, and the like. Every appraiser employs such income statement adjustments in the process of adjusting (normalizing) historical income statements. Regardless of the name given to them, there is virtually universal acceptance that Type 1 Normalizing Adjustments are appropriate.
- Type 2 Normalizing Adjustments. These adjustments normalize officer/owner compensation and other discretionary expenses that would not exist in a reasonably well-run, publicly traded company. Type 2 Normalizing Adjustments should not be confused with control adjustments or Type 1 Normalizing Adjustments.
These adjustments reveal the income stream that is the source of potential value for the minority investor. Normalizing adjustments also reveal the base income stream available to the controlling interest buyer who may be able to further enhance that income stream.
Appraisers should not be confused by the fact that minority shareholders of private companies lack the control to make normalizing adjustments. Some have argued that because minority shareholders lack the ability to change, for example, things like excess owner compensation, normalizing adjustments should not be made in minority interest appraisals. This position is simply incorrect, although it is enduring among appraisers.
Minority shareholders of public companies also lack control. However, they expect normalized operations. If management of a public company receives egregious salaries, or fails to reasonably manage expenses, minority shareholders of the public company will invest their money elsewhere. And the market value of such companies normally reflects this lack of investor interest exposing incumbent management to the threat of hostile takeover (followed shortly thereafter by unemployment).
Shareholders of nonmarketable minority interests generally lack this ability to “take my money and run.” These considerations have no impact on the underlying value of the enterprise. Rather, they reduce the value of the interest in the enterprise in relationship to its pro rata share of enterprise value. This diminution of value must be considered separately from, but in conjunction with, the valuation of the enterprise.
STATUTORY FAIR VALUE AND NORMALIZING ADJUSTMENTS
Normalizing adjustments can be important in statutory fair value determinations. If excess owner compensation is considered part of how a company is operated, then controllers of corporations have the control to artificially lower “fair value” and at the same time, benefit from the reduction in the form of non prorata distributions.
That may be “fair” in some jurisdictions, and part of the “operational reality” of a business. However, normal appraisal procedure would call for normalization of earnings prior to determining enterprise value.
This discussion on normalization adjustments could provide useful information to courts in their determinations of statutory fair value. Judges should make equitable decisions in light of relevant valuation theory and practice.
To remind readers, this series of posts on statutory fair value relies heavily on my book (with Travis W. Harms) Business Valuation: An Integrated Theory, 2nd Edition.