Everybody knows that companies are priced based upon multiples of earnings, but what earnings are they talking about? Is it net income, earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA)? For small middle market companies (revenues from $5 to $50 million), the multiples are generally applied to EBIT or EBITDA.
Interestingly enough, the most important annual return is probably net cash flow, which is not necessarily any of the above. Net cash flow is derived by subtracting capital expenditures from gross cash flow (EBITDA). When minimal capital expenditures are expected in the future, EBITDA will be a close approximation of net cash flow. When future capital expenditures are expected to about equal depreciation, EBIT will be a good proxy for net cash flow.
As an important footnote to the debate over EBIT or EBITDA, both pricing methods assume a debt-free transaction (i.e., the seller is responsible for paying its interest-bearing debt, either by reducing the purchase price or paying the interest-bearing debt in full at closing). Most M&A professionals use EBIT in pricing companies. Theoretically, capital expenditures in a growing company should at least equal or exceed depreciation over the long term, making EBIT a more accurate estimate of net cash flow than EBITDA. Yet EBITDA is still used in some industries.
According to Bruce Wasserstein, the legendary dealmaker and author of Big Deal, EBITDA multiples are preferred for companies in more capital-intensive industries, in which depreciation is a more significant factor, because such multiples correct for the impact of differential depreciation. That is not to say, however, that the multiple will be the same without regard to whether it is being applied to EBIT or EBITDA.
In small middle market transactions, investment bankers often refer to EBIT and EBITDA when they actually mean adjusted EBIT and adjusted EBITDA, it being understood that net income is adjusted for extraordinary, nonrecurring and discretionary items. Of course, there is often considerable debate over what constitutes an extraordinary, nonrecurring or discretionary item, but suffice it to say that the seller wants to add back every significant expense and every unusual loss that it can reasonably argue is warranted.
Here are some factors that are considered in deciding on an appropriate EBIT multiple:
Small middle market companies generally trade at multiples of 5 to 7 EBIT, but there are so many exceptions to this general rule that one hesitates to proclaim the general rule. In the end it usually requires the judgment of a seasoned M&A professional to decide upon an appropriate multiple. Owners of less profitable businesses often cannot believe that their operating assets are worth only 5-7 times EBIT. They are often familiar with price to earnings multiples (P/Es) of their favorite public stock, but they do not realize that P/Es are applied to after-tax net income rather than earnings before interest and taxes. Depending on the corporate tax rate and the corporate interest expense, a multiple of 5 times EBIT may translate to a P/E of 10 or more. In some cases, assets may support a higher value than earnings. If so, net asset value may represent a fair selling price for the business, but no amount of wishful thinking will support a value that combines net asset value and earnings value because buyers will not pay twice for the same assets. Multiples of EBIT and EBITDA indicate the value of the operating assets.
Other adjustments necessary to arrive at the indicated value of the entire company include adjustments for nonoperating assets (e.g., the company beach house), excess or insufficient working capital and interest-bearing debt. While this article may tempt you to estimate a fair selling price for your business using the EBIT approach discussed, we don’t recommend it.
It requires considerable judgment and experience to determine acceptable normalization adjustments, to select an appropriate multiple based on specific risks, and to adjust the indicated value for nonoperating assets. We, of course, recommend that you use an investment banker such as ourselves, but if you decide not to use an investment banker be sure to consult with someone qualified in pricing businesses.