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For What It’s Worth: Earnings? Fuhgeddaboutit! – February 2016

After the Civil War, the United States embarked upon a century of unparalleled economic growth, spurred by the railroad, automotive, steel, and related industries. These businesses required huge amounts of capital. Their founders had to turn to outside investors. These investors, although possibly serving as directors, did not usually assume active management roles. Naturally they wanted to know how their investments were doing. This gave rise to financial accounting and reporting, as we know them today. The introduction of corporate income taxes created a similar need for tax accounting and reporting.

Central to both disciplines was the concept of matching revenue and expense, which led to the concept of depreciation (spreading the costs of capital outlays over their useful lives) and accrual accounting. This created the accounting and tax concept of earnings, which is very different from cash flow. Earnings reflect matched revenue and expense. Cash flow, on the other hand, is the change in cash position during a period.

The fascination with earnings peaked during the 1960s conglomerate era, during which accounting rules permitted mergers under the “pooling of interests” method that gave the false appearance of organic growth created by combining the unadjusted results of formerly independent businesses. When investors saw through that, conglomerates, except for General Electric and a few related exceptions, fell out of favor.

Earnings, however, mean nothing to private company owners!

  • They are an accounting abstraction, not real value added.
  • You cannot spend earnings: you can only spend cash.
  • Private company owners usually seek to minimize earnings to reduce their taxes.
  • Earnings are based on depreciated historical costs, which may bear no relation to current asset market values or replacement costs due to inflation.
  • Earnings are determined under complex accounting and tax rules, which may be manipulated.

The objective of a rational private company owner is to maximize his or her wealth through dividends (current income) and appreciation (long-term value growth). This is measured (appraised) by cash flow available to equity shareholders, which is the change in cash during a period before dividends but after all other obligations, such as working capital, capital expenditures, and debt service, have been discharged.

A corollary is that comparisons between cash flow oriented private companies and earnings-oriented public companies are often specious because private companies try to minimize earnings while public companies try to maximize them.

Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call.

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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.

Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.

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