Evaluating a business with volatile earnings

Introduction

One of the hardest situations to evaluate is a business with volatile earnings.  Evaluation multiples will evaluate the company at a specific time. And in cases where there is consistent growth or decline, these can be factored in. But when the earnings are erratic these figures are very subjective at best or completely erroneous at worst. Here’s how evaluating a business with volatile earnings can be done.

How are erratic earnings caused?

Erratic earnings can be caused by external changes in the market or internal factors of the business.  If any future earnings is predicted, the impact of these changes on the Business Needs to be analyzed. This will help to arrive at a meaningful evaluation.

So what are some of the external factors on a business?

Small as well as large economic changes in the target market can have a big affect on the smaller business.  There may be a change in the competition nearby. These changes may also be in the environment affecting the location of the company. There could also be a fluctuation in business because of losing or gaining a big customer.

Some business sectors are prone to more volatility. This is because they are affected by events in the business world or even global events. Technology, oil and gas and healthcare/pharmaceuticals are a few of these volatile industries to name a few.

What are some external factors of erratic earnings?

Some of the internal factors that could cause erratic earnings may include:

  • a change in products and services,
  • the pricing of the products and services,
  • the attaining of new equipment,
  • increase or decrease in the workforce, especially of key workers,
  • or maybe a change in location.

There may also be a discrepancy between changes in the cost of production compared to the pricing.

In order to assess these factors, it is necessary to have a good knowledge of appropriate accounting methods. Additionally, a thorough knowledge of the industry in which the business is working is also needed. Account needs to be taken of the stage of growth also.  Some factors will seem negative and a reason to believe that future earnings will be reduced. Whilst others will be positive and when taken account of will give reason to believe that future earnings will increase. Once the analysis has taken place a new multiple can be worked out. This can be done by making predictions on the earnings based on these analyses.

There may be cases where the earnings still remain unpredictable.  This makes the company a very high risk to any buyer.  One solution to this, in order to get some sort of reasonable price for the business, a deal may need to be agreed that includes earn out.

To Sum Up

In summary, mid market businesses can be prone to erratic earnings making them very difficult to evaluate fairly. Evaluating a business with volatile earnings can be made simple with knowledge and practice. Analysis needs to be done to work out what is causing the erratic earnings. And the multiple needs to be adjusted so that it is based on predictable earnings.  If this is not possible the business will seem very high risk to any buyer. It will consequently be then sold at a lower price. One of the ways to help get the price deserved is to include an earn out in the deal.

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