Valuations frequently assume a third party will purchase a business and primarily run it unchanged. This does not mean a buyer will continue to pay expenses or a level of expense not considered typical. Non-operating assets are typically excluded from a valuation, too. Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.
Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements. Expenses related to layoffs are an example of operating but non-recurring expenses generally removed. If an income source or expense is not related to ongoing operations, it is subject to adjustment.
Discretionary adjustments look to income sources or expenses over which an owner has a choice. Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment. Rent paid to a related party is often based on the cash flow requirements of that related party. For a property with no mortgage, for instance, below market rent may be paid. This is an example of how adjustments can work as a reduction of expense or an addition to expense.
Various authoritative sources report officer/owner compensation based on industry type, size and location. These sources can form the basis for this adjustment. Real estate appraisals are frequently used as the source for an adjustment to market rent.
Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest. Opponents say no, correctly stating a minority owner has no control over these discretionary expenses. Proponents argue these adjustments should always be considered. Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment. A growing lack of investor interest leads to a decline in share price.
Proponents point to the derivation of yields used when calculating value based on cash flow. These yields are often based on data from public equity markets. As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.