Understanding the historical and forecasted earnings for a business is a key part of any business valuation. One important item for the valuation analyst to consider when analyzing historical and future earnings performance is whether the target business is involved in any related-party transactions.
If the business were sold to a third-party buyer, the transactions with previously related parties may be charged at different prices once the relationship with the previous owners is lost.
For example, let us consider everyone’s favorite celebrity Kim Kardashian West. In a hypothetical scenario, we will assume that Kim’s popular beauty and fragrance line, KKW, is owned through a company (“Company A”) that purchases its various product ingredients from a range of suppliers. Company A purchases aloe from another beauty products company (“Company B”) that is partially owned by her half-sister, Kylie Jenner. Due to the familiar relationship between owners, Company B sells aloe at a discount to Company A for $2 per ounce, but sells to all of its other third-party clients for $3 per ounce. Other aloe suppliers in the market also charge $3 per ounce.
Company A sells its aloe-based face cream for $10 per bottle, and total costs to create the product amount to $6 per bottle, which includes the $2 for one ounce of aloe used in each bottle. This results in earnings margins of 40% per bottle for Company A. Without the relationship with Company B, however, margins would only be 30% per bottle, since one extra dollar would be charged for the aloe. If 1,000,000 face cream bottles are sold per year, resulting in $10,000,000 in annual sales, purchasing aloe from Company B creates a $1,000,000 annual savings for Company A.
This simplified example shows how discounts given to related parties can translate into inflated earnings margins (in the case of Company A), or deflated earnings margins (in the case of Company B). Potential buyers of Company A would consider the costs that they would incur when running the business, and the discount on aloe would not be available if Kim was no longer an owner. Therefore, with all other factors held constant, removing the impact of the aloe discount would result in a lower valuation for Company A.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.