Why Quality of Earnings study is critical in arriving at the correct valuation?

During acquisition, the buyer values the seller based on the financials presented by the seller and the future projections that the seller thinks it can achieve.In other words, the buyer pays the seller based on the current and future projected earnings of the target company.

In many cases either knowingly or unknowingly the seller tries to inflate and manipulate the earnings by taking advantage of the accounting rules.

For instance, a company can show increase in its earnings either by increasing its sales or by reducing its taxes paid by changing its depreciation calculation.
In both the cases, the company shows an increase in earnings but it is the quality of earnings that matters more to the buyer as by increasing its sales organically the earnings are sustainable where as using accounting standards to increase the depreciation and reducing taxes are not sustainable.

When is Quality of Earnings report prepared?

As the Quality of Earnings report is important to the buyer to confirm whether he has put the correct assumptions in valuing the target, the buyer generally assigns this activity to a third party consultant.The consulting firm analyses each financial number provided by the seller and validates the same with a supporting evidence.

Role of Accounting firm and how is Quality of Earnings different from an Audit?

Quality of Earnings report is not an audit exercise.

Although the consultant would be more comfortable if the financial statements prepared by the seller are already audited, the consultants would be focused if the earnings provided are due to the organic increase in sales through marketing campaigns and better products and service offerings of the seller or due to lower cost structure of the seller due to huge focus on execution, delivery and controlling expenses.
It is also important that the Financials statements prepared by the seller align to the GAAP accounting standards.The seller provides a proforma Financial statements and adds back one time expenses or income that the buyer will not have once the company is acquired.The proforma numbers provided by seller should not vary a lot against the GAAP statements as post acquisition, the buyer needs to prepare the consolidated Financials based on GAAP.

Considerations in Quality of Earnings study

Once the consulting firm starts due diligence on the target financials, following are the common areas of concern which it detects that are a red flag to the buyer for proceeding further.

Share Buyback

This is generally applicable for public companies.Many public companies resort to share buyback to inflate its Earnings per share as share buybacks will reduce the number of shares outstanding which can increase the EPS growth.The bigger concern would be when the company borrows money for share buybacks.This would mean that the company is not confident of its growth or sees risk in its business but does not want to disclose the same to its investors by showing EPS growth.With high EPS, the PE ratio of the company reduces which shows that the company is undervalued.This prompts the investors to buy more shares which in turn increases the stock price of the company.

Working Capital Changes

In many cases the company reports increase in its sales by providing easy credit terms to its customers.This increase in income is followed by increase in account receivable. This is a red flag as the company is not growing due to its unique products and services but by extending easy credit terms.This can be generally seen where the company reports an increase in net income but the free cash flow will be negative.

EBITDA vs Free Cash Flow

Although many companies are valued in the basis of their EBITDA, the company still needs to pay taxes, interest to its debtors and depreciate its assets.EBITDA is just an indicator of how much earning are due to company’s operations.As acquisitions are done to increase shareholders values, important metrics here is the Free cash available with the buyer after accounting for the incremental working capital and additional capital expenditures.Hence the buyer would be very keen to have the Free cash flow numbers as close to its Net income.This confirms to the buyer that Quality of Earnings of the target business is high.

Customer and Supplier Concentration

In addition to the earnings, the consultant would also be interested where are these earning coming from.If most of the earnings are from single customer then it brings a greater risk to the buyer.The buyer needs to prepare a mitigation plan to ensure that the customer does not exit post acquisition. In addition to the customer analysis, the revenues by product/service offerings is also analyzed to check for its risks.

Pricing and Competitor Analysis

Analysis should also be done on the pricing standard followed by the target company.If the pricing is premium, then it needs to be investigated why the target commands a premium pricing and in what ways are its services superior to competitors and whether this premium pricing shall sustain in future.Is the market and business environment growing or declining and what impact will it have on the pricing. If the target increases its pricing, will the customers stick to the target or move to its competitors. In other words whether the service offerings provided by target are unique or commoditized.

Cost Structure of the Target company

Attention needs to be paid how the target company controls costs.Are there systems in place that capture information through which steps are taken to control costs?
If it is a service company, the employee costs are analyzed to see if they are paid more than the market standard.If the wages are below the market standard then it has to be investigated why the employee continues to work with the company.Is it due to the better working culture and the other career opportunity available that makes the employees stick with the target company.
The supplier costs and other expenses like professional fees and restructuring costs are also taken and and adjusted to the EBITDA if the buyer would not be engaging these suppliers in future thus reducing costs.

Capital Expenditure Analysis

When analyzing the target company, care should be taken to ensure if the additional investments or expenditures are required to attain future growth.
The current CAPEX investment is analysed to confirm if the target needs to invest money for additional investments in compliance and regulatory front.In companies like Banking, companies needs to invest additional capital to adhere to increased regulatory and compliance standards.The buyer needs to check if those investments are already done by the target or whether he needs to make those investments post acquisition.

Under reporting of Liabilities

In many cases the seller under reports its expenses and liabilities to show better earnings.
In some cases at the time of acquisition, the bonus payments would not have been paid to employees but no liability provisioning would be done for this amount to be paid in future.
In other cases the owners under report their salaries to increase earnings.There would have been many vacancies for important roles that needs to be filled by target and the suitable budget for this would not have been allocated.In some cases the pension contributions of target employee would not be done by the target.All these issues needs to be seen in detail and risks taken into account.

Contigent Liabilities

Target would have been involved in legal disputes which would not have been solved.Hence the target should provision these liabilities arising out of Litigation in its balance sheet.

Financial Projections by seller

In addition, proper due diligence needs to be done on the seller’s projections to check if these projections are realistic. The projection needs to be substantiated with supporting evidence.If the target projects a 20% growth in revenues then the pipeline and backlog needs to be analyzed to check if the target can achieve that growth or whether the target has overstated the numbers.

Conclusion

The Quality of earnings report is extremely critical for the buyer to confirm if his assumptions on valuation is correct.If Quality of Earnings is bad then this will derail the deal thereby reducing the final purchase value and in some cases have changes in earn outs structure and addition of indemnification provisions in the SPA agreement.
To avoid this and ensure deal certainty, more sellers are doing their Quality of Earnings analysis before looking at potential buyers.This ensures that seller is prepared to respond any question from the buyer during due diligence.In addition the seller understands the risks in its financials quality and can make corrections accordingly. The buyer would also be more confident about the financials provided by seller thus reducing the delay in signing the deal.



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