How discretionary spending effects a business valuation.

Discretionary spending is spending that must be done for the long term profitability of a company, but may be postponed from the current period(s). This includes equipment replacement, equipment upkeep (often referred to as repairs and maintenance), marketing, research and development and training.

Discretionary spending may be expensed in the current period (as in the standard practices for equipment upkeep, marketing and training), or capitalized and allocated to costs based on their expected life (such as depreciation of equipment replacement or amortization of leasehold improvements). The research and development costs may have been expensed in the current period or capitalized and amortized.

Because the value of most businesses is based on discounting, or a multiple of, future anticipated profits, analysis of the discretionary spending may have a significant impact on the valuation of the company.

On capitalized discretionary costs, the spending has already been “normalized” in the calculation of the business earnings or profits. However, if the amount of current spending ahs been less than the amount depreciated or amortized, the valuation should include some provision for additional capital spending required soon. This may be done by subtracting the previous capital spending shortages from the purchase price based on multiples of earnings.

Discretionary costs that are expensed in the current period have an even greater impact in that, in addition to the expenditure required for previous deficiencies, they affect the current reported earnings and estimate of future earnings.

An illustration of the effect on business valuation is shown by examining the valuation of 4 companies identical in every way but their discretionary spending policy. Each shows the effect on the valuation of the business.

Company A – discretionary spending based on a percent of sales

Year 1 Year 2 Year 3 Projected

Sales $100 $110 $120 $130

Direct Costs $50 $55 $60 $65

Indirect Costs
Fixed $25 $25 $25 $25
Discretionary $20 $22 $24 $26

Profits $5 $8 $11 $14

Valuation based on 4 x expected profits

= 4 x $14 = $56

This is an example of a company, which realizes that discretionary spending is a function of doing business in the long term and allocates a percent of their sales towards discretionary spending.

We will use this as the model company

Company B – straight line discretionary spending

Year 1 Year 2 Year 3 Projected

Sales $100 $110 $120 $130

Direct Costs $50 $55 $60 $65

Indirect Costs
Fixed $25 $25 $25 $25
Discretionary $20 $20 $20 $20

Profits $5 $10 $15 $20

Valuation based on 4 x expected profits

= 4 x $20 = $80

This company was likely overvalued by $30.

It is less likely that the company will reach the $130 sales figure, and the spending on discretionary costs will likely be higher. The valuation should reflect a normalized expected profit of $14, as in Company A, and the value should be reduced by the discretionary expenditure increase required to make up for the shortfall ($6) of the past 2 years.

Compared to Company A, this should be worth less than $50 ($56 - $6).

Company C – spend when there’s money to spend

Year 1 Year 2 Year 3 Projected

Sales $100 $110 $120 $130

Direct Costs $50 $55 $60 $65

Indirect Costs
Fixed $25 $25 $25 $25
Discretionary $18 $22 $26 $30

Profits $7 $8 $9 $10

Valuation based on 4 x expected profits

= 4 x $10 = $40

This business is likely undervalued by more than $16.

The $130 projected sales may be surpassed because of discretionary spending spent on research and development, marketing or training. Based on $130 sales and “normalized” discretionary spending, the profits should be projected as $14.

Compared to Company A, this company should be worth more than $56, because of recent discretionary spending.

Company D – declining discretionary spending

Year 1 Year 2 Year 3 Projected

Sales $100 $110 $120 $130

Direct Costs $50 $55 $60 $65

Indirect Costs
Fixed $25 $25 $25 $25
Discretionary $20 $18 $16 $26

Profits $5 $12 $19 $26

Valuation based on 4 x expected profits

= 4 x $26 = $104

This company is likely overvalued by over $60.

It has been gutted of future revenue generators and dressed up. This may be dressed up for sale of the company, inflated stock prices (often used in conjunction with stock options) or to dress up the value of the CEO.

Similar, but worse Company B, it should be valued at less than $44 ($56 - $12 discretionary expenditure increase required to make up for the previous two year shortfall in discretionary spending).

The above examples show how discretionary spending can affect reported and projected profits and the effects that they may have in the valuation, and sales price, of a business.

When purchasing a company, investors should analyze its previous discretionary spending. This discretionary cost analysis can have a significant impact on the sales price and variance between likely and projected future earnings.

Byron Lund is President and CEO of Bizwiz Consulting Group Ltd., an international business analysis product developer and vendor which performs consulting services in business analysis, improvements and turnarounds in Calgary, Alberta, Canada. Further information is available at www.bizwiz.ca .