The Importance of a Quality of Earnings Study

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This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Family Business Director blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.

Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.

A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).

What Is a Quality of Earnings Study?

A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.

Ongoing earning power is a key component of valuation

Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.

Analysis performed in a QoE study can include the following:

  1. Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.
  2. Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.
  3. Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring.

The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:

  • Workforce / employee analysis
  • A/R and A/P analysis
  • Customer Analysis
  • Intangible asset analysis
  • A/R aging and inventory analysis
  • Location analysis
  • Billing and collection policies
  • Segment analysis
  • Proof of cash and revenue analysis
  • Margin and expense analysis
  • Capital structure analysis
  • Working capital analysis

For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:

  • The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.
  • A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers’ perception of the company and its products.

The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations

The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.

Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.

Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.