A Company may have loss or negative earning for many reasons caused by short term or long term factors. Short term or medium term losses are mostly caused by temporary factors whereas long term reasons are mostly in permanent nature. Temporary issues affect one or certain number of companies such as worker unrest, change in the consumer preference or a product recall, sector-wide problems like down turn in the price of an item or similar issues, seasonal or cyclical reasons, and many others. Long term reasons may be attributed for issues like operating or strategic problems, out dated plan, poor investments in the past, lack of proper work force, too much debt or financial problem, wrong strategic choices in terms of product mix or marketing policy, inefficient operation, etc.
The Consequences of Abnormally Low or Negative Earnings in Valuing Companies
Negative earnings are caused by a deterioration of the overall economy. A firm with negative earning is more difficult to value than a firm with positive earning. Because you are never sure whether the firm will be able to outlive its problems and restructure it or will go bankrupt. Further, long term problems are in very rare cases are conceptual but are mostly significant from a measurement standpoint. Further, you can never determine a precise growth rate and use it in valuation. If you once determine a growth rate based on the current negative earning and apply it to determine the future growth rate, that rate will be more negative. Projecting positive anticipated scenario is almost impossible. Applying analyst’s estimate of growth is really difficult. Assessments of future tax liability or valuation based on going concern assumption are mostly mere guesswork.
Valuing Negative Earnings Companies
The first step involved in valuing a company with negative earning should explore the reasons why the firm has negative earnings. If the company has negative earning with some short term issues, we may assume that the company will be able to recover its earning in near term. We simply have to replace the current negative earning with its normal positive earnings. Calculation of normalized earnings will depend on the nature of the problem. If the problem relates to a particular company we should apply firm specific approach, concentrating on the issues involved within the firm. If the reason of the loss can be attributed to some specific event and the account system can estimate loss occurred due to such event, the task becomes simpler. But, if the loss or expenses cannot be separated from other expenses the task becomes tougher. In such case, expense items of the firm for the current year with negative earning should be compared to the same item in normal previous years and scaled to revenues. If any item looks abnormally high it should be normalized with earlier normal figure. Some accountants often make adjustments with the figures of earlier years when the company had made large acquisitions because the year with negative earning is skewed by large expense items that are generally non-recurring and similar to the acquisition, yields nil or no immediate revenue.
Valuing a business is always done through the eyes of the buyer (investor). There are a minimum 39 ways of valuing a business. When a company has a low or negative earning the best method of valuation should be asset approach. Under this approach, assets are classified in two groups—tangible and intangible. An equipment appraiser will assess the type and condition of the equipment, and its availability in a “used equipment” marketplace to provide a fairly accurate look at its value. There are generally three values to consider. These are the in-place-in-use value, the orderly liquidation value; and the auction value. Inventory and accounts receivable will also be adjusted from their balance sheet value. The assets which should appreciate in value (e.g., real estate) or which will be depreciated from a buyer’s point of view should be made with necessary adjustments to arrive at a fair market value. Goodwill is an intangible asset, difficult to appraise. That should be assessed as well from a buyer’s point of view. A prudent buyer assesses such value from a close look on the future prospects and profit in near three to five years.
The value of the company with negative earning is made through the evaluation of total asset value as explained above and the expected future prospects.