Normalising earnings

Reported earnings are not always representative

The profit and loss account of a given year can include items that are unlikely to recur, such as a one-off restructuring cost, an insurance settlement, or a gain from selling an asset unrelated to the company's core activity. Using such a year's earnings without adjustment would overstate or understate the company's ongoing capacity to generate results.

Normalisation is the process of identifying these items and adjusting the earnings figure so that it better reflects what the company can be expected to generate in a typical year, rather than the specific circumstances of one period.

Common categories of adjustment

Non-recurring costs, such as legal disputes, relocation expenses, or costs tied to a specific project that has since ended, are commonly added back. Similarly, income from a one-off event, such as a subsidy received for a single year or a gain on the disposal of an asset, is typically removed from the base used for the valuation.

Adjustments can also relate to items that recur but are not set at market terms, which is addressed separately when it involves matters such as director remuneration or related-party transactions affecting the reported result.

Adjustments require supporting evidence

An adjustment is only as reliable as the evidence behind it. A cost described as exceptional should be traceable to a specific event in the accounts or supporting documentation, rather than asserted without a clear basis. This is part of why a valuation professional will typically request explanations for unusual variations between years.

Ter illustratie, a company that recorded a legal settlement cost in one year, clearly identifiable in the notes to the accounts, might see that cost added back for the purpose of establishing a normalised earnings base, while the remaining years are left unadjusted.

Normalisation affects both the formula's shortcomings and the valuation report

The statutory formula uses EBITDA exactly as reported, without any normalisation. This is one of its structural limitations, since a company whose reported earnings were affected by a one-off item in the relevant year will see that distortion carried directly into the formula's result.

An independent valuation report, by contrast, is expected to examine the composition of reported earnings and adjust for items that would otherwise misrepresent the company's ongoing performance, before applying any valuation method.

Documenting the reasoning behind each adjustment

A defensible valuation report sets out each normalisation adjustment individually, with the reasoning and the source in the accounts, rather than presenting only a final adjusted figure. This transparency allows a reader, including a tax administration, to trace how the reported figures were used and why.