It is a question that owners and buyers often consider. Frequently, the answer is tied to a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), leaving the further question, “What is EBITDA worth as a key factor in value metrics?”

“What is this business worth?”

Fundamentally, what a business is really worth is a number between what the owner will take and what the best buyer will pay. The range presented by those numbers is where negotiations can bring the two together, assuming the buyer’s maximum is equal to or more than the seller’s minimum.

Methods are available to help the buyer and seller derive estimates of value based on assumptions and calculations, which can help in decision making and in the communication and negotiation between buyer and a seller. Because that process can raise many complexities, it is common for valuation discussions to be based on simplifying measurements.

EBITDA is probably the most common approach today. Is EBITDA worth its weight in mathematical gyrations to determine it? Yes – but that is a nuanced answer.

Valuation models can be as simple as applying a rule-of-thumb multiple of revenues or can include highly complex representations of future cash flows or other profit measures, also ignoring or factoring into the mix various add-ons or deductions for intellectual property, goodwill, assets and liabilities, and many other factors.

In the sphere of business sale transactions, quite often the parties rely heavily on multiples of EBITDA. While the term may be bandied about casually, it is essential to understand that there are many variations of what EBITDA means and when and how it should be used in valuation considerations.

Appraisal educators state that all value is a prophesy of the future. Like science buffs, they also teach that the past is a key for assessing future expectations. Value calculations are efforts to try to consider the past and the future to determine the “value” of a business. They always fail in perfection, as the best efforts derive only an approximation of what might be the value of the business, often expressed as one point in a range of possible values.

In theory, if perfectly applied, all the various approaches and methods – such as multiples of net profit, cash flow, revenues, EBITDA, seller’s discretionary earnings, net book value and scores of others – might be expected to reach same value conclusions for the same business. Of course, they never yield the same answers in practice. Normally, they are not even close. But each view can help evaluate value within a range.

EBITDA is a leading factor for weighing the worth of a business, and it is so common that it enjoys “coin of the realm” status. It is used not because it is perfect or right, but because it is widely accepted and simple to apply. However, even well-informed people talking about the EBITDA of a business may be talking about quite different things.

Earnings before interest, taxes, depreciation and amortization present an easy but incomplete calculation of EBITDA for transactions. That is because, in most cases, it is best to consider an “Adjusted EBITDA.” Even that is by no means pure, because different people may perceive, understand, and accept adjustments differently.

What then are some of the possible adjustments that will yield a relevant number?

Discretionary expenses.

Smaller businesses are seldom managed to create maximum taxable income. Instead, they are managed to create benefit for the owner. “Business” expenses might be made at the owner’s discretion in areas such as paying an owner above- or below-market compensation, unusual benefits, paying a relative above market rent, or others. Perhaps they can be justified, but they are not truly relevant to the business.
All things being equal, if continuing these outlays would not be needed under new owners, then they may be valid adjustments to EBITDA.

Extraordinary expenses.

Business expenses that, in all probability, will never recur are legitimate targets for adjustment. Examples are such things as a loss incurred in a 100-year flood or the expenses or revenues of a permanently discontinued business activity. Expenses made in support of introducing a new business line should be evaluated, as they may represent “dead weight” outlays incurred historically for earnings to be generated at some later time but not yet seen in past earnings.

Accounting treatment.

By choice, some expenditures, such as the buildout of new shop space using company labor or materials, may have been expensed but should have been capitalized and are possible adjustments. Similarly, perhaps there were revenue or expense items, spanning multiple years, that were not “booked” until completed. They, too, are potential adjustments.

 

Other factors besides a measure of earnings must be considered in analysis of value, such as:

Capital expenditures.

Does the company have ongoing capital needs? If they are substantial, then imputing a capital expenditure load, perhaps as economic depreciation, may be necessary to account for this burden against cash-based earnings. When this factor is predominant, as in a capital-intense business such as heavy equipment rentals, EBIT may be more appropriate than EBITDA.

Transferable earnings.

Value to a buyer presupposes that the seller’s earnings will be effectively transferred to the buyer for the future. Obstacles that may require value adjustments include customer concentrations, disruptive competition or innovations, deferred maintenance costs, seller relationships that drive business, continuation of key employees, and others.

Conclusión

In summary, because of its prevalence, EBITDA is worth a lot in support of deal-making. At the same time, value assessments often center on Adjusted EBITDA. Through skilled analysis of the “rest of the story,” the worth of Adjusted EBITDA or any other method of valuation becomes far more relevant and is worth much more to a decision maker.

Sellers who fail to have their value analyzed and assessed, to discover and allow for the full range of adjustments and factors, will likely misperceive value and may well leave a lot of money on the table in closing a business sale. An experienced deal maker, such as a certified M&A broker and advisor, can be “worth their weight in gold” in guiding an owner to obtain their best understanding of market value and then produce full valued outcomes for their business owner clients in a business sale.

If you have questions about exit strategy or valuation for your company, our M&A advisors can help. Feel free to contact them here.

 

*This article originally appeared on IBG Foxfin site.

Reece Adnams

Director general y director ejecutivo global

Reece Adnams es el director ejecutivo y director general global de Eaton Square, un asesor de fusiones y adquisiciones y servicios de capital para tecnología, servicios y otras empresas en crecimiento fundada en 2008.

[email protected] 61 03 8199 7911 eatonsq.com