DETERMINATION OF FUTURE MAINTAINABLE PROFIT :

Determination of future maintainable profits, based on past record is a delicate and complicated task as it involves not only the objective consideration of the available financial information but also subjective evaluation of many other factors, such as capabilities of the company’s management, general economic conditions, future Government policies, etc. Guiding principles can be laid down only in respect of the former and the valuer will have to give due consideration to the other matters according to his reading of the situation in each individual case. The steps necessary to arrive at the future maintainable profits of a company are: (a) calculation of past average taxed earnings; (b) projection of the future maintainable taxed profits; and (c) adjustments of preferred rights.

(a) Calculation of past average earnings: In order to calculate the past average earnings, it is necessary to decide upon the number of years whose results should be taken for averaging; select these years and adjust their profits to make them acceptable for averaging.

The number of years to be selected must be large enough so as to cover generally the length of a business cycle; an average for a shorter period might not be suitable. But it should not go too far back, e.g., results in the 80’s will have no bearing on the results expected in the 90’s. In inflationary conditions, that are present today, it is considered that a relatively shorter period may be more representative since it reveals more recent results. Similarly, for companies having steady and gradual growth, average of a shorter period is more useful. In some unusual circumstances, average of still shorter period or even only one year’s profit may be more significant in estimating future earnings, such as where a change in the business or a change in trading conditions forces the valuer to discard earlier years and to rely upon one year only or to select certain normal years and exclude others. In all these matters, a sound reasoning would alone aid the valuer. Whether a 3 yearly, 5 yearly or longer average would reflect the correct future earnings of a company mostly depends upon the nature of the individual case.

The followings are some items which generally require adjustment in arriving at the average of the past earnings:

(i) Elimination of material non recurring items such as loss of exceptional nature through strikes, fires, floods and theft, etc., profit or loss of any isolated transaction not being part of the business of the company, lumpsum compensation or retiring allowances, damages and costs in legal actions, abnormal repair charges in a particular year, etc.

(ii) Elimination of income and profits and losses from non-trading assets.

(iii) Elimination of any capital profit or loss or receipt or expense included in the profit and loss account.

(iv) Adjustments for any interest, remuneration, commission, etc., foregone or overcharged by directors and other managerial personnel.

(v) Adjustments for any matters suggested by notes, appended to the accounts or by qualifications in the Auditor’s Report, such as provision for taxation and gratuities, bad debts, under or over provision for depreciation, inconsistency in valuation of stock, etc.

(vi) Taxation: According to the opinion of the valuer, the tax rates may be such as were ruling for the respective years or the latest ruling rate may be deducted from the average profit. However, the consensus of opinion is for adjusting tax payable rather than tax-paid because so many short-term reliefs and tax holidays might have reduced the effective tax burden.

(vii) Depreciation: It is a significant item that calls for careful review. The valuer may adopt book depreciation provided he is satisfied that the rate was realistic and the method was suitable for the nature of the company and they were consistently applied from year to year. But imbalances do arise in cases where consistently written down value method was in use and heavy expenditure in the recent past has been made in rehabilitating or expanding fixed assets, since the depreciation charges would be unfairly heavy and would prejudice the seller. Under such circumstances, it would be desirable to readjust depreciation suitably as to bring a more equitable charge on the profits meant for averaging.

In averaging past earnings, another important factor comes up for consideration is the trend of profits earned. It is indeed imperative that estimation of maintainable profits be based only on the available record, i.e., the record of past earnings, but indiscrete use of past results may lead to an entirely fallacious and unrealistic result.

In this regard, three situations may have to be faced. Where the past profits of a company are widely fluctuating from year to year, an average fails to aid future projection. In such cases, a study of the whole history of the company and of earnings of a fairly long period may be necessary. If the profits of a company do not show a regular trend, upward or downward, an average of the cycle can usefully be employed for projection of future earnings. In some companies, profits may record a distinct rising or falling trend from year to year; in these circumstances, a simple average fails to consider a significant factor, namely, trend in earnings. The shares of a company which record a clear upward trend of past profits would certainly be more valuable than those of a company whose trend of past earnings indicates a static or down-trend. In such cases, a weighing average, giving more weight to the recent years than to the past, is appropriate. A simple way of weighing is to multiply the profits by the respective number of the years arranged chronologically so that the largest weight is associated with the most recent past year and the least for the remotest. (Similarly, if net worth is under consideration, the respective years average net worth may also be weighted in a similar way).

(b) Projection of future maintainable taxed profits: Projection is more a matter of intelligent guesswork since it is essentially an estimation of what will happen in the risky and uncertain future. The average profit earned by a company in the past could be normally taken as the average profit that would be maintainable by it in the future, if the future is considered basically as a continuation of the past. If future performance as the company is viewed as departing significantly from the past, then appropriate adjustments will be called for before accepting the past average profit as the future maintainable profit of the company. These are stated below:

(i) Discontinuance of a part of the business;
(ii) Under-utilisation of installed capacity;
(iii) Expansion programmes;
(iv) Major change in the policy of the company; and
(v) Adjustment for rehabilitation and replacement.

(c) Adjustments of preferred rights: In arriving at the average profits and their future projection, all charges including interest on debentures and other borrowings are of course deducted. But the dividend on preference shares should also be considered after the estimate of future profits has been arrived at. Dividends payable to preference shareholders, according to the terms of their issue, should be deducted from the maintainable profit.