Consider both quantitative and qualitative assessments

In mergers and acquisitions, the target company’s financial statements provide the numbers to support the selling price. But how sustainable are those quantitative results? Increasingly, investors are obtaining quality of earnings (QOE) reports from independent business valuation experts to find the answer.

Looking to the future

Buyers, sellers, and investors must look beyond historical financial statements. QOE reports help identify internal and external trends that may provide value-building opportunities — or threaten a company’s future performance.

Consider these examples: Fifteen years ago, there were roughly 9,000 Blockbuster Video stores worldwide. In the early 2000s, the founders of Netflix tried to convince Blockbuster to purchase their struggling start-up for $50 million. Blockbuster declined the offer numerous times, because the start-up was unprofitable.

Today, Netflix has grown to a market cap of roughly $150 billion by staying focused on market trends. In doing so, Netflix has capitalized on changes in technology and transitioned its distribution model from DVD-by-mail rental to on-demand Internet streaming. Perhaps a QOE report might have helped Blockbuster identify and capitalize on these trends?

Instead of choosing Netflix, Blockbuster chose to partner with Enron Broadband Services to launch a video-on-demand service. That deal fell apart in 2002 after news broke about Enron’s scandalous financial statement fraud. Again, a QOE report might have revealed some alarming trends about this joint venture partner.

Eventually, Blockbuster filed for bankruptcy in 2010 and was bought out by Dish Network for $320 million a year later. Today, only one Blockbuster store remains open. A QOE report might have helped Dish Network recognize that Blockbuster’s prospective earnings weren’t sustainable in the 21st century.

These examples show how historical results are only relevant to the extent that they can be used to predict net free cash flow to investors in the future. QOE reports interpret the target company’s historical results in the context of today’s market conditions. This analysis can help identify trends that may cause future performance to differ from what’s happened in the past.

Digging deeper

QOE reports evaluate the details underlying the target company’s earnings. For instance, gross profits may be broken down by geographic region, salesperson or product line to understand what’s making money — and what’s not. Examples of operating issues that may be unearthed in a QOE report include:

  • Customer or supplier concentration risks,
  • Seasonal cash or human capital shortfalls,
  • Deferred equipment purchases and maintenance,
  • Bad debts,
  • Obsolete technology,
  • Dependence on a key person,
  • Capacity constraints,
  • Undisclosed related party transactions,
  • Pending litigation,
  • Emerging competition and substitute products, and
  • New government regulations.

Another important metric that may be evaluated in a QOE report is earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA isn’t audited — and it can mean different things to different people.

In a QOE assessment, EBITDA is typically adjusted for such items as owners’ compensation and other discretionary spending, nonrecurring revenue and expenses, and accounting methods that differ from industry norms. It’s also important to recognize that depreciation and amortization may not approximate the amount that the company would need to spend on long-term assets. 

In addition, the QOE assessment typically includes ratio analysis to identify trends and determine possible causes. For example, suppose a company’s inventory has increased substantially over the last three years. The increase might be expected if the company’s revenue is growing. But it might also be a sign of poor inventory management practices or obsolete inventory. The inventory turnover ratio (average inventory ÷ cost of sales × 365 days) can help determine what’s happening. 

Customizing a QOE report

A business valuation professional has been training to conduct an independent QOE report that suits your needs. These experts focus on what matters most to hypothetical buyers and sellers — expected net cash flow — and they’re sensitive to the confidentiality concerns that may arise in M&A situations.