Traditional business valuation fundamentals, techniques and theory, as currently taught to analysts in NACVA’s Consultants’ Training Institute (CTI), indicate that earnings before taxes (EBT) is the starting point for normalizing historical earnings under the Capitalization of Earnings Method in the Income Approach.

Normalization adjustments are applied to the EBT benefit stream and then tax affected to determine normalized net income. An average or weighted average is then applied to the normalized net income stream for the years that represent the best proxies for the future, which results in an estimate of future earnings/future cash flows.

The analyst faces a potentially major issue when using EBT as the starting point for normalizing future earnings in this manner.  The issue arises when assumptions used in forecasting key expenses for normalized earnings differ from the way those expenses were calculated in the historical EBT. Key expenses that can have a large impact on ultimate value include non-cash items and related capital expenditures as well as interest expense and debt assumptions.


Normalizing earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of EBT may eliminate this problem.  For analysts who apply the CTI method of normalizing historical EBT, learning how to properly normalize historical EBITDA instead of EBT can provide a solution to issues often encountered when trying to reconcile average historical depreciation and interest to projected future depreciation and interest.  This article is intended to provide a solution to the discrepancies often encountered and to eliminate these unintended inconsistencies.

We will begin with a few observations:

  1. Normalizing historical non-cash items like depreciation can be time consuming and adds no benefit to the determination of future earnings when cash flows are the appropriate benefit stream to be used in an income approach.
  2. Depreciation and amortization used to determine future earnings and future cash flows should be forward-looking. They should not be determined based on historical depreciation and amortization unless the entity has constant historical annual capital expenditures and depreciation methods and rates that are expected to continue into the future.  In any case, depreciation and amortization expense used to determine future earnings and future cash flows should be consistent.
  3. Depreciation and amortization expenses used to determine future earnings and future cash flows should include future depreciation and amortization on existing property, equipment, and intangibles as of the valuation date as well as on future expected capital expenditures which will be necessary to support projected operations.
  4. Future depreciation and amortization expense incorporated into the future benefit stream should be determined using straight-line depreciation. A consideration for identifying future cash flows might also include using tax-allowable depreciation and amortization methods and rates in the calculation of income taxes.
  5. Operating interest expense that is used to determine future earnings and future cash flows should be forward-looking. It should not necessarily be based on historical interest expense, rather the interest expense used to determine future earnings and future cash flows should be consistent with future debt service fluctuations.
  6. A hypothetical willing and able buyer acquiring a controlling interest in a subject entity will attempt to optimize debt capital, to the extent
  7. Optimized debt capital can be determined using the borrowing capacity of the subject entity, which is based on a variety of factors such as industry levels of debt to equity, specific company collateral coverage, debt service coverage, and fixed charge coverage. For this exercise, the analyst should be using an interest rate as of the valuation date that is consistent with the market and industry with consideration of the creditworthiness of the subject entity.
  8. Optimized debt capital may also be considered when valuing a lack-of-control interest in some valuation engagements, depending on the purpose, standard of value, premise of value, and facts and circumstances of the engagement – primarily in litigation situations when fair value is being sought. The valuation analyst should follow the same assumptions used in optimizing debt capital of a controlling interest (when and where it is appropriate) in determining the optimized debt capital for a lack-of-control interest in those cases where the lack-of-control value aspects are ignored based on the purpose and standard of value.
  9. Income taxes should be determined using current effective tax rates as of the valuation date, applied to projected taxable income of the subject entity. The valuation analyst should modify these rates if there is knowledge of a known change in the statutory rates as published.

The problem with using EBT as the starting point for normalizing historical earnings is that distortion can be caused by the difference between the methods used to calculate historical depreciation, amortization, interest, and taxes, compared to the methods used to calculate future values for these variables.  It is easiest to illustrate this problem with an example.

To aid in the use of normalized EBITDA as your starting point and to help the users of your report to understand how historical EBITDA was determined, it is helpful for the entity’s historical income statements to be presented in a manner that itemizes historical EBITDA, EBIT, EBT and net income.