The last three to five years of financial statements are often on the list of documents appraisers use to value a business. But historical results are only relevant to the extent that similar results are expected in the coming years. If so, historical trends may be used to help forecast future performance.
How do business valuation professionals handle major changes, such as new government regulations, increasing direct costs or the purchase of a major piece of automation equipment? For many retailers, restaurants and manufacturers, these are more than just hypothetical scenarios. They’re real-world changes that are likely to unfold under the U.S. Department of Labor’s (DOL’s) new overtime regulations, scheduled to go into effect on December 1, 2016.
Understanding the new regs
In every business valuation assignment, the expert considers internal and external factors that may impact value, including any changes in government regulations. To illustrate, the DOL recently increased the income threshold for nonexempt workers to $47,476 a year. That’s more than double the existing income threshold of $23,660 a year.
On the flip side, exempt employees aren’t required to be paid overtime for working more than 40 hours a week. The DOL has also updated the income threshold for “highly compensated” employees who are automatically exempt from overtime pay to $134,004 a year. (Prior to December 1, the threshold for highly compensated employees is $100,000 a year.) Both income thresholds are scheduled to be adjusted every three years, starting in January 2020.
What about employees who fall in the middle of these two categories? For workers earning more than $47,476 but less than $134,004 after December 1, employers must perform a duties test to determine whether they should receive overtime pay.
The DOL estimates that more than 4 million workers will be reclassified under the new overtime rules. To avoid paying overtime, some companies may opt to use more part-timers or independent contractors during seasonal peaks. Others may reduce benefits to offset the incremental overtime costs. But it’s likely that the changes will significantly lower earnings for certain businesses, no matter how hard they try to minimize overtime hours.
Measuring the impact
When valuing a business that’s affected by the updated DOL regs, experts usually ask 1) how the updated rules will affect future earnings, and 2) how management plans to minimize the adverse effects. There are several possible ways that the new law could impact expected cash flow:
If a company decides to replace people with machines, the decision could fundamentally change its product costing. That is, direct labor would be replaced by an overhead allocation for equipment usage. The company’s balance of debt and equity would also change if the automation equipment were financed with debt. In theory, this could affect the company’s cost of capital in future periods.
Taking a holistic approach
The updated overtime rules are just one example of how a company’s operating environment could change. The company’s expected performance may be affected by countless internal and external factors, such as the loss of a key person or customer, a significant reduction in the corporate tax rate, a major cyberbreach, or the emergence of new technology.
Experienced valuation professionals take no shortcuts when valuing a business. It’s a time-consuming process that requires research, finesse and expertise.
Sidebar: Watch out for shortcuts in forecasted future cash flow
Before valuing a business based on estimates of future cash flow, valuation professionals ask: “What changes are on the horizon?” While business appraisers aren’t fortunetellers, some changes may be known (or knowable) on the valuation date.
With some companies, it’s possible to simply take historic financial statements and apply an assumed growth rate into perpetuity. But experienced valuation pros know that future performance can’t always be expected to mirror the past. One key reason future performance may vary is capacity constraints.
To achieve an expected growth rate, a larger facility or additional equipment may be needed over the long run. Alternatively, if a decline is expected, a smaller facility, salary cuts and layoffs can help preserve cash flow over the long run.
Often, management creates budgets for internal planning purposes. These documents can provide insight into the company’s expected cash flow by highlighting emerging opportunities and threats, but they need to account for major changes in operations. If not, a valuation that’s based on the budget won’t be accurate.
Experts generally rely on management’s representations, including any internally prepared forecasts, when estimating the value of the business, as long as the representations appear accurate and unbiased. But company insiders need to view them with scrutiny, too.
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