After a long day of work, it is not fun to feel like you stepped into an industrial freezer during the short walk from your car to your doorstep. That is exactly how I have lived during the past two winters in Cleveland, though. I love this city, but it seemed like every other day I would look at the dashboard in my car and see the outside temperature reading below zero. One has to wonder, what does this winter have in store for us?
While 2013 and 2014 were some of our harshest winters ever, winter 2012 may give hope to those of us in Cleveland. That winter was one of our warmest, with the eighth warmest February and warmest March on record. Taking into consideration the large swings in temperature from one year to another, one may ask, how can temperatures be so drastically different from year to year?
Valuation analysts face an analogous dilemma when analyzing a company with erratic historical profits. A part of any valuation includes a review of the company’s historical financial results and an analysis of its historical profitability levels. If profit levels swing wildly over the historical periods analyzed, it can be difficult to predict future profit levels.
For example, take a company that has generated profits of $50,000 in year 1, $300,000 in year 2, and a loss of ($25,000) in year 3. The valuation analyst will need to gain an understanding of what drove the fluctuations from year to year. To do this, he or she will conduct an interview with management in an effort to identify the reasons for the volatility. This management interview enables the analyst to identify any normalizing adjustments that might be appropriate to take into account non-recurring events that have impacted results. After making such normalizing adjustments, the fluctuations in a company’s profitability levels may become less extreme. (For more information on this normalizing process, please see my blog titled “Normalizing Adjustments in Business Valuation”
In addition to the analysis of historical results, the management interview also provides the valuator with an opportunity to examine and evaluate management’s expectations for future revenue and profitability levels. If management believes that year 1 and year 2 (as noted above) are most reflective of the company’s future performance, the valuation analyst can place more weight on the financial results from those years and less weight to the results from year 3 in an effort to better project future profits. This weighting technique enables the analyst to consider more heavily the historical years that best represent the company’s expected future performance.
By closely examining historical operating results and reviewing those results with management, a valuation analyst is better able to make normalizing adjustments that reflect recurring operating results and profitability and, at the same time, better develop an expectation of future profits when historical results are erratic.
While most Clevelanders expect each winter to be snowy and cold, that is not always the case. Similarly, a skilled valuation analyst will not fall into the trap of overlooking the potential volatility in a company’s historical earnings as predictive of future results.