future-valuation-57570402Often, the list of documents appraisers use to value a business include the last three to five years of financial statements. Historical trends may be used to help forecast future performance, but historical results are only relevant to the extent that similar results are expected in the coming years.

How do business valuation professionals handle major changes, such as new government regulations, increasing direct costs or the purchase of a major piece of automation equipment? For many retailers, restaurants and manufacturers, these are more than just hypothetical scenarios. They’re real-world changes that are likely to unfold under the U.S. Department of Labor’s (DOL’s) new overtime regulations.

New regulations review

Experts consider internal and external factors that may impact value in every business valuation assignment, including any changes in government regulations. For example, the DOL recently increased the income threshold for nonexempt workers to $47,476 a year. That’s more than double the existing income threshold of $23,660 a year.

On the flip side, exempt employees aren’t required to be paid overtime for working more than 40 hours a week. Also, the DOL has updated the income threshold for “highly compensated” employees who are automatically exempt from overtime pay to $134,004 a year. (Prior to December 1, the threshold for highly compensated employees is $100,000 a year.) Both income thresholds are scheduled to be adjusted every three years, starting in January 2020.

For employees who fall in the middle of these two categories, earning more than $47,476 but less than $134,004 after December 1, employers must perform a duties test to determine whether they should receive overtime pay.

It’s estimated by the DOL that more than 4 million workers will be reclassified under the new overtime rules. Some companies may opt to use more part-timers or independent contractors during seasonal peaks to avoid paying overtime. Others may reduce benefits to offset the incremental overtime costs. But it’s likely that the changes will significantly lower earnings for certain businesses, no matter how hard they try to minimize overtime hours.

Measuring the impact

When valuing a business that’s affected by the updated DOL regulations, experts usually ask 1) how the updated rules will affect future earnings, and 2) how management plans to minimize the adverse effects. There are several possible ways that the new law could impact expected cash flow:

  • Professional fees paid to external payroll and accounting firms to help implement changes to accounting systems and meet additional recordkeeping requirements could increase.
  • Direct labor costs and salaries paid to administrative personnel and middle managers could increase.
  • Over the long run, some companies may purchase automated equipment, such as robots or self-checkout kiosks, if labor rates become cost-prohibitive.

The decision to replace people with machines could fundamentally change a company’s product costing. That is, direct labor would be replaced by an overhead allocation for equipment usage. If the automation equipment were financed with debt, then the company’s balance of debt and equity would also change. In theory, this could affect the company’s cost of capital in future periods.

Consider a holistic approach

The updated overtime rules are just one example of how a company’s operating environment could change. The company’s expected performance may be affected by countless internal and external factors, such as the loss of a key person or customer, a significant reduction in the corporate tax rate, a major cyber breach, or the emergence of new technology.

Experts generally rely on management’s representations, including any internally prepared forecasts, when estimating the value of the business, as long as the representations appear accurate and unbiased. But company insiders need to view them with scrutiny, too.

Valuing a business is a time-consuming process that requires research, finesse and expertise, and experienced valuation professionals take no shortcuts during the process.

© 2017