Valuing a Business; Four Basic Factors of Earnings...
Updated: Mar 3, 2021
Two businesses for sale could have the same dollar value for “earnings” and yet they should be valued far from equal. We have listed four factors of earnings below that tell more about the earnings than just the number.
Quality of Earnings
Quality of earnings measures whether the earnings are padded with a lot of “add backs” or one-time events, such as a sale of real estate, resulting in an earnings figure which does not accurately reflect the true earning power of the company’s operations. It is also not unusual for companies to have “some” non-recurring expenses every year, whether for a new roof on the plant, a hefty lawsuit, a write-down of inventory, etc. These non-recurring expenses or incomes should be adjusted for.
Sustainability of earnings after the acquisition
The key question a buyer(s) should considers is whether they are acquiring a company at the peak of its business cycle or if the earnings will continue to grow at the previous rate? Do they have skills and experience to be able to maintain and grow the earnings of the business?
Diversified earning sources
Both buyers and sellers should look into buying and building a business with varied sources of revenues. Businesses that are not dependent on just a few customers or a singular industry will certainly command a premium over a business that depends on just a couple of big customers or businesses that are cyclical in nature. Businesses with recurring sources of income are generally valued higher than businesses that have a one-time revenue model.
Authentication of information
The concern for the buyer is whether the information is accurate, timely, and relatively unbiased. For example, has the company allowed for possible product returns or allowed for uncollectable receivables or accounted for gift cards that have been issued etc. etc.?