Having a difficult time understanding when to use normalized earnings instead of reported earnings. Specifically, the question below uses reported earnings.
Assume a minority shareholder holds 10% of a private firm’s equity, with the CEO holding the other 90%. Using normalized earnings, the value of the firm’s equity is estimated at $20 million. The CEO refuses to sell the firm and the minority shareholder cannot sell their interest easily. A discount for lack of marketability (DLOM) of 15% will be applied. A discount for lack of control (DLOC) will also be estimated. Using reported earnings instead of normalized earnings provides an estimated firm equity value of $19 million. Which of the following is closest to the value of the minority shareholder’s equity interest?
The answer used the reported earnings. Is it related to the fact that the CEO will not sell the firm anytime soon?
Interesting question. I’m curious why too. I was under the impression that using normalized earnings is always preferrable to using reported ones.
To take a wild guess, though, could it be because in this scenario, you don’t have much control over the management and cannot correct (i.e., normalize) the firm’s deteriorating performance?
As a minority shareholder, you do not have any control or influence over the company’s operations. Thus, you cannot change the cost structure regardless if you think current management is doing an aweful job. As such, you essentially have to accept the reported earnings when valuing a minority / noncontrolling interest bc you have no recourse to change them. By using reported earnings, the cash flows inherently reflect a discount for lack of control for the reasons I stated. You could either value a minority interest this way, or value a controlling interest and then apply a discount for lack of control; they are theoretically the same.
Normalized earnings are preferred bc when you are valuing something, you want economic reality. However, you may have no say if your objective is to value a noncontrolling interest. Nevertheless, if an owner is paying himself 5x market compensation, if you make no adjustment, the company will appear cheap…this is not economic reality and will stick out like a sore thumb if you compare to guideline companies whose managers are paid at market rates. The question of fair market value then comes in to play.