What is EBITDA? The acronym stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Charlie Munger, Warren Buffet’s long-time business partner, calls EBITDA “bullshit earnings.” I think he said that because he has seen lots of pitch books where investment bankers focused on EBITDA and forgot about capital expenditures and net cash flow.
We will focus on EBIT and EBITDA in this handbook, but we won’t forget about capital expenditures, because they are real and necessary to fuel the growth of companies, or even to replace productive assets in companies that are not growing. To the extent that there might be any “bullshit” in the way some business owners and market participants think about EBITDA, we will try to take it out as we look at this almost universally used measure of gross cash flow in business valuation and business transactions.
We begin with a definition of enterprise value. The net income of a business is the return to the equity owners of that business. But many companies borrow money and have lenders as additional stakeholders. For that reason, it is helpful to look at value inclusive of the interests of equity holders and lenders, or debt holders.
A few private companies also have preferred stock and preferred shareholders, but for our purposes, we will ignore preferred stock right now.
We can look at enterprise value and the relationship to equity value.
Enterprise value is the sum of market value of equity (on an operating basis) and interest-bearing debt less the amount of cash on a company’s balance sheet. The cash is considered to be an offset to debt (and operating equity).
Enterprise value is referred to as a total capital value because it includes both equity and debt. This value becomes the numerator when calculating multiples. For example, the EBITDA multiple is enterprise value divided by EBITDA.
Beginning with enterprise value, if we subtract debt, we obtain market value of equity (operating basis). If we then add cash, which is effectively assumed to be a non-operating asset [there might be an occasional exception], we arrive at the total value of the equity (operating basis plus cash).
The enterprise multiples we develop are often called “cashless” multiples. If we included cash, companies with large amounts of cash (e.g., Apple and Microsoft) would reflect multiples that are influenced by their cash levels, which would not be comparable or reasonable for application to companies with relatively less cash.
If we observe enterprise values for similar companies to a subject private company in the marketplace and corresponding levels of EBIT or EBITDA, we can calculate EBIT and EBITDA multiples. These can be used as a basis for inferring the enterprise value of private companies.
The same would be true of observed transactions involving the sale of similar companies, if adequate information is available. We see again that the numerator in the calculation of EBITDA or EBIT multiples is enterprise value. For a more detailed discussion of enterprise value see here.
ABC Private Company Equity and Enterprise Values
We began by saying that valuation is [not] easy and talked about the concept of fair market value. Then we introduced the Gordon Model and developed equity-based multiples for ABC Private Company based on some reasonable assumptions.
In this post, we look at what are called total capital, or enterprise-level earnings indications like Earnings Before Interest and Taxes (EBIT) and Earnings Before Interest, Taxes, Depreciation and Amortization (EBIDTA). In addition, we will look at EBIT and EBITDA multiples to see how they compare with equity-based multiples like the net income and pre-tax earnings multiples. This discussion should be helpful for business owners and market participants.
ABC Private Company’s recent income statement is summarized below.
ABC had recent revenues of $10.0 million and net income of $1.0 million, reflecting a 10% net income margin. ABC is profitable. For now, we assume a 40% tax rate, ignoring for the moment any differences between effective corporate tax rates for C corporations and tax rates applicable to owners of tax pass-through entities. We also ignore President Trump’s recent goal to reduce federal corporate taxes to a 15% corporate rate.
Where is EBIT on this income statement? One might infer that operating income is EBIT, but we will calculate it directly.
Where is EBITDA on this ABC income statement? It is not there because EBITDA is not a GAAP (Generally Accepted Accounting Principals) concept. We must derive it.
We looked on other financial statements to find depreciation and amortization of $500 thousand and develop EBIT and EBITDA below.
EBIT is the sum of pre-tax income and interest expense, or $1.77 million. We add depreciation and amortization ($500 thousand) to arrive at EBITDA of $2.27 million. The EBITDA margin is 22.7%, so this company has relatively healthy profitability.
How do we value ABC? We have already derived the P/E for net income (10.0x) and the multiple applicable to pre-tax income (6.0x). We also want to look at enterprise value and the EBIT and EBITDA multiples.
To do so, we have to know that the Company has about $1.8 million of debt. The average and ending debt balance suggests that the pre-tax cost of debt is 5.67%. We will need this figure later. In the table below, we calculate equity values (cash is zero) using the multiples just noted for net income and for pre-tax income. We develop enterprise value based on the calculated equity value and the EBIT and EBITDA figures in the table above.
At this point, please accept this back door derivation of the EBIT and EBITDA multiples. We will confirm their validity shortly.
In the two left-most columns, we see that the Market Value of Equity (Operating, because there is no cash) is $10.0 million. This is the product of $1.0 million of net income and the P/E multiple derived above of 10.0x. We obtain a similar market value of equity result capitalizing pre-tax income with the derived multiple of 6.0x. Note that market value of equity is in the numerator of these two multiples.
Now, we know from above that enterprise value is the sum of market value of equity and debt (less cash of zero), or $11.76 million ($10.0 million plus $1.76 million). Using the derived enterprise value and the EBIT ($1.76 million) and EBITDA ($2.27 million) figures shown above, we can calculate the implied EBIT multiple of 6.66x and the EBITDA multiple of 5.19x.
Note that the market value of equity derived from subtracting debt from enterprise value is the same $10.0 million derived using equity-based earnings measures. This has to be, because the same company at the same time has the same value. And we are forcing this result for purposes of illustration and discussion.
Assume for the moment that the market value of equity for ABC Private Company is $10.0 million. There is no “bullshit” in EBITDA if an appropriate multiple of EBITDA is used in ABC’s valuation. In this case, the 5.19x multiple of EBITDA we derived yields the very same $10.0 million equity value that we know to be the “true value” of equity in this hypothetical example.
Observe also that in order to derive appropriate indications of market value of equity or enterprise value, appraisers and market participants must apply multiples that are appropriate for each different income measure. Market value of equity is the numerator for equity-based multiples. Enterprise value is the numerator for total capital multiples.
This last observation is important for business owners. Quite often, there is considerable confusion in the marketplace about what observed or “heard of” multiples really mean. Just because XYZ Company sold for an 8.0x multiple of EBITDA does not mean that this relatively high multiple is applicable to ABC Private Company. As we see above, the appropriate EBITDA multiple for ABC is 5.19x. We don’t know the reasons that XYZ sold for an 8.0x multiple, and we may never know.
When business owners sell their companies, they don’t desire to receive fair market value for their equities. They desire that a strategic or synergistic buyer appears and pays a much higher price. We will discuss strategic concepts later. What they really desire, though, is that an irrational buyer will show up.
Unfortunately, strategic or synergistic buyers can be hard to find when you want to find them. And irrational buyers don’t come along sufficiently often to rely on irrational pricing.
What we are beginning to see is that it is important for business owners to know something realistic about business valuation. The coverage in this handbook is geared to arm business owners and their advisers with a realistic understanding of what drives business value.
As we proceed, we will also talk about what owners can do, now, to work on increasing value before a company is put on the market for sale and before that buyer comes along with an unexpected offer.
Valuation is important for business owners for many reasons. One of these reasons is for the operation of buy-sell agreements. If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.
I’ve priced it at $2.99 so you won’t have to think about the expense. So click on the image of the book. You will be taken to Amazon. Then buy the book. Don’t be mislead by the price. It is a full length book. If you like it, as most readers have, please take a few minutes and review the book on Amazon!
In the meantime, be well!