Partner
CPA, Head of Consulting, MBA
M&A Vocabulary – Understanding the Experts: “Normalized Earnings”
In this ongoing series, rotating M&A experts from RÖDL's global offices introduce an important term from the English technical language of transaction business, along with notes on its usage. The focus is not on scientific-legal precision, linguistic subtleties, or exhaustive presentation, but rather on conveying or refreshing the basic understanding of a term and providing some useful insights from consulting practice.
A Normalized Earnings Analysis is essential for M&A processes. It aims to present a company’s earning power, adjusted for the impact of non-operating and one-off effects or structural changes that have occurred recently or are planned after the transaction—so-called pro-forma adjustments.
To illustrate this, see the example below. Let’s assume a hypothetical scenario in which an investor has only the following information about Companies A and B to make an investment decision, with all other factors being equal:
It is likely that, due to the identical margin profile, the investor would have no investment preference or would be willing to invest in Company B, which shows a higher nominal result. However, reported earnings can be distorted by non-operating and one-off effects. Gains from the sale of fixed assets are a common example of non-operating income.
Assuming the scenario described above occurs and all other factors remain the same, Company B sold fixed assets in the 2022 financial year and achieved a profit of EUR 2,000k. This impact should be considered and adjusted by a potential investor:
Regardless of how well a company is managed, including its accounting, there will always be events that do not result from the core business.
Therefore, Normalized Earnings are an indispensable analysis in mergers and acquisitions, as they form the basis for forecasts and thus for Business Valuation. Buyers are not willing to pay for non-recurring results.
Therefore, a normalized result is an acceptable basis for Business Valuations and Purchase Price Negotiations. In this regard, events such as land sales, reversals of provisions, legal disputes, financial gains or losses, etc., do not relate to the core business, which requires an in-depth normalization analysis.
Such an examination usually takes place as part of a due diligence, which is typically performed by the buyer’s advisor. In this process, the advisor analyzes the quality of the target company’s earnings and adjusts for the impact of non-operating or one-off effects. This allows investors to assess the target company’s underlying profitability.
Furthermore, the analysis of normalized earnings can reveal the “true” potential of a target company. A clear example of this is a company with a positive operating result where one-off items have a negative impact on the net result, meaning the underlying profitability would be higher after adjustment. Finally, it is also important to point out that a normalized analysis can be performed at different earnings levels. For example, adjusted EBITDA is frequently used in mergers and acquisitions and, although EBITDA should naturally only contain operating results, some extraordinary events can also be recorded at its reported level. In other industries, adjusted EBIT may be used, as the depreciation of fixed assets is an important aspect for the buyer.
From the newsletter
“Corporate Law, Deals & Capital Markets” To our
M&A Vocabularies