Editor's note:This article is a contributed piece by Brian Garfield, Managing Director at global advisory firm Lincoln International. The views expressed are solely those of the author.

The challenges brought by the pandemic have prompted CFOs to consider: should incremental adjustments to EBITDA be included when measuring a company's profitability? For a long time, lenders and sponsors have accepted EBITDA adjustments as a way to estimate a company's profitability and reflect the buyer's assessment of performance. Adjustments commonly recognized in the industry—especially in compliance certificates between sponsors and lenders—include one-time expenses such as litigation or transaction-related costs, as well as non-cash expenses such as impairment charges and stock-based compensation.

An unprecedented shock like the pandemic seemed to provide a textbook opportunity for a significant increase in EBITDA adjustments, as companies sought to normalize earnings. Surprisingly, however, the adjustment magnitude (already limited) has narrowed since the pandemic began: from 24.4% of EBITDA in Q4 2019 to 21.8% in the same period of 2020. Even more surprising, according to Lincoln International's analysis of a database of over 1,700 companies, primarily private portfolio companies, only 1.6% of adjustments were directly related to the pandemic.

Given the above, it seems unlikely that companies would not consider earnings adjustments, which may indicate that companies are adopting different approaches to estimating normalized earnings. When CFOs evaluate a company's profitability, a key question arises: should pandemic-related losses and costs be added back? Or is the industry beginning to accept different ways of measuring company performance?

Company-Specific Approach

The answer depends on the company itself and its industry context. For businesses whose demand was impaired during the pandemic, it is difficult to argue that demand will recover to historical levels and adjust EBITDA accordingly. However, for businesses that experienced demand disruption, there is a strong case that operations will eventually recover to pre-pandemic levels, making it reasonable to include adjustments.

When evaluating appropriate value drivers, buyers and sellers are balancing the priority of historical performance while being willing to consider additional metrics. But in cases where a company has been severely disrupted, a CFO can convincingly argue that the last twelve months (LTM) EBITDA during the pandemic is not the correct valuation driver, as it fails to capture the company's true profitability. In such cases, alternative earnings measures should be considered.

Determining Value Drivers

The events of 2020 were unpredictable and beyond expectations. The market recognized that earnings needed normalization, but the extent of normalization remains highly debated. Sellers will not sell at trough earnings, but buyers need assurance that lower earnings levels are not the new normal. Therefore, three strategies have become popular in measuring profitability during this period.

1. Annualized Earnings

For some businesses, operations in Q4 2020 had already recovered more than during the peak of the pandemic. For businesses disrupted in the spring, annualized earnings—whether using the last quarter annualized (LQA) method or annualizing results from after June—may more accurately reflect business performance than full-year 2020 metrics.

2. 2021 EBITDA

If CFOs have greater confidence in assessing 2021 EBITDA—given clearer visibility into the full-year budget, including contracted revenue and full implementation of cost reduction measures—they may prefer to focus on 2021 performance and place less weight on 2020 results.

3. Month Replacement Method

Another workaround for LTM EBITDA is to replace the months most affected by the pandemic with earnings results from the same months in 2019. Replacing those months with 2019 results is a simple way to reflect the actual levels that were previously achieved.

Regardless of the path chosen, it is crucial to select a defensible metric. Evaluate key performance indicators (KPIs) to ensure that the normalized metric is one that market participants would genuinely rely on. One strategy is to stress-test the approach as a valuation team would in due diligence discussions. Ask yourself: If cost savings realized in 2020 are included, are these temporary or permanent cost reductions? Does growth require incremental costs? Have you ever achieved these earnings levels?

Ultimately, when considering any earnings normalization or adjustment, be careful not to overstate EBITDA and ensure you can provide clear rationale to support your position. Buyers and sellers will inevitably raise questions.