What Does it Mean to Normalize Earnings? Why is this Important?

Value is prospective. In valuing a business, the valuator is trying to determine what a notional buyer would pay today for a series of expected future cash flows. For large companies or companies undergoing rapid growth or significant changes in their business, this usually requires the development of a detailed cash flow forecast looking several years into the future. For most small to medium-sized privately-held businesses this level of sophisticated forecasting is simply not undertaken. An owner may have a reasonable estimate as to what sales might be in the next fiscal year, but likely wouldn’t be able to estimate expected cash flow over several years.

For stable businesses, past performance is generally relied upon in order to develop an expectation for future cash flows. Depending on the nature of the business and industry, this may require a review of the last three to five years of earnings. This review is undertaken with a view to developing an expectation of future earnings and accordingly, may require a number of adjustments to be made in order to ‘normalize’ earnings that may be reasonably expected to occur in the future. Essentially, the valuator is looking to eliminate one-time, non-recurring items from past earnings. In addition, adjustments may also be made for ‘discretionary’ shareholder expenses – that is, expenses incurred by the shareholder that while still considered to be business expenses, would not need to be incurred by the business in the normal course of operations.

A few examples of common normalization adjustments include:

  • abnormal bad debt expense;
  • one-time business interruptions due to fire, flood, abnormal weather conditions, etc.;
  • earnings from special projects or contracts not expected to recur;
  • rent expense or management salaries where these items are not transacted at fair market value; and,
  • unnecessary meals and entertainment, travel or promotion expense.