CAUTION: Multiples of EBITDA Ahead
By Russ Warren,
A buyer is willing to pay a certain amount for a business’ future cash flows, aka Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). But, because future cash flows are uncertain, a proxy is needed.
Thus, we have the storied ‘Multiples of EBITDA’ bandied about club locker rooms for decades. Few concepts in finance have generated more confusion or irrational angst. A selling owner once told me,‘Oh, it’s a good price, but I think the multiple is a bit low.’ Really!
Multiples of What? Let’s start with EBITDA, which we’ve defined above – or have we?
EBITDA is gross cash flow. It is useful in comparing the earnings (and hence value) of companies because it looks through differences in financing structure (interest), corporate structure (taxes), capital investment policies (depreciation) and the wake of past acquisitions (amortization of goodwill).
Which EBITDA? There is more than one EBITDA candidate to be multiplied. Is it the current year’s annualized? Trailing Twelve Months’ (TTM)? Latest full year’s? In a cyclical industry, the average over the cycle? Since the buyer is buying future cash flow, it is arguable that in a growing business next year’s EBITDA, if supportable, is the most meaningful. If forward-looking EBITDA cannot be convincingly supported, TTM (the most recent actual) is often used.
What Adjustments to EBITDA? What would EBITDA be if another owner operated the business? For example, should there be adjustments (or “add-backs”) for:
- Expenses at the owner’s option (‘discretionary expenses’) – e.g. owner compensation and perks above that necessary for capable a hired CEO
- Compensation for employees that will not continue under new ownership (net of any replacement cost)
- Non-recurring expenses – e.g. a new IT system, major lawsuit, above-market rent to related parties
- ‘Negative add-backs’ if any; like the loss of a major customer or drop in product selling price (Think Oil) or an owner paid less than market (it happens)
In sum, which EBITDA is used significantly impacts the implied valuation of the business. A business owner ‘talking on the first tee’ rarely mentions, or even thinks about the underlying subtleties mentioned here.
The Multiple bulks up EBITDA into an ‘Enterprise Value’. That is, the value a buyer pays for the cash-free and interest-bearing debt-free business. In either an asset or a stock transaction, the Buyer gets the assets and assumes the normal operating payables and accrued expenses.
How Does the Multiple Relate to Return on Investment? If a buyer pays five times TTM EBITDA and the company generates the same EBITDA next year, the buyer gets a 20% free cash return before deducting interest, income taxes and capital expenditures. If next year’s EBITDA is higher, the buyer earns more than 20%, if lower, vice versa.
So, What Determines the Multiple? Buyer demand, which is based on attributes like predictability of earnings, concentration risk, outlook and synergy. Company size plays into each of these determinants, and is therefore one of the most predictable drivers.
Size Matters. There are break points based on size. Interest from private equity groups begins at about $1 million of EBITDA. A greater number of PE firms are seeking $3 million and more yet $5 million. (Think ‘Return on Bother’) A different set of larger PE acquirers salivate at $10 million. Strategic acquirers need something big enough to ‘move their needle’, so a small business must have something very special – e.g. strong intellectual property, a sizzling brand name, or strong cost synergies (Think plant shutdowns and layoffs) – to attract their attention and fetch a high multiple.
Factors raising the Multiple include strong management, proprietary products or services, pricing power, recession resistance and a growing, defendable market niche.
Factors lowering the Multiple include customer concentration, no CEO successor or weak management bench strength, supplier vulnerability, poor financial records, the inability to forecast reliably and other discernible risks.
What Multiples Are We Seeing? Our firm advises sellers on middle market M&A transactions with $2-to-15 million of EBITDA. Middle market M&A pricing at mid-year 2017 is as strong as it has been in the last 40 years. (“Subject to change without notice”, as they say.) We are seeing today one to three turns of EBITDA higher than prevailed during the downturn of 2008-10.
The take-away is you need to understand what EBITDA is appropriate to use and what value enhancers and detractors apply to the Company. Use Multiples of EBITDA with CAUTION.
Use them as a reality check to test the market reasonableness of company-specific, future-oriented valuation methods like Leveraged Buy Out (LBO) and Discounted Cash Flow (DCF) financial models.
To achieve the highest multiple, and enterprise value, you need to create strong buyer demand – an orchestrated competition among motivated buyers for your business, but that’s a story for another day.