One of the most common metrics for buying and selling a business is an Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) multiple. Phrases like, “I can get you six times” or “I wouldn’t pay more than four times for that company” are commonplace among business brokers, but to the layperson these terms can be somewhat misleading. It is customary for buyers and sellers alike to talk in terms of EBITDA multiples as a simplistic approach to derive a perceived value for a particular business.1 While an EBITDA multiple may get someone in the ballpark, it is certainly lacking a number of critical elements, which if not considered could result in a very poor transaction for the buyer or seller.
The primary reason that buyers rely on an EBITDA multiple when valuing a company is that EBITDA is erroneously viewed as the “cash flow” of the business, and the multiple is “what the market is paying.” However, EBITDA fails to consider other aspects of cash fl ow such as expected ongoing capital expenditures and working capital required by the business, while the “market multiple” fails to capture the specific risks associated with the subject company’s cash flow.
Let’s assume for a minute that Company A and Company B are both going on the market. They are both manufacturing companies that produce the same widget. Processes and procedures for the two companies are identical. Company A has revenue of $7 million and EBITDA of $1 million, while Company B has revenue of $5 million and EBITDA of $800,000. Mr. Jones, a potential buyer, has been doing some research and found that the “going rate” for a manufacturing company is five times EBITDA based on the transactions he reviewed. Therefore, Mr. Jones has used market transactions to price the companies at $5 million and $4 million respectively, with the assumption that an investment in either would result in a similar return on his investment. On the surface, this may seem reasonable. However, a number of pitfalls may be encountered.
Pitfall No. 1: Mr. Jones’s blanket application of a five times multiple fails to consider the risk of each specific company. While some portions of a company’s risk are truly market-related, others are very specific to the business being acquired, and a blanket application without further analysis could greatly overstate or understate the value of the target.
Pitfall No. 2: Mr. Jones did not consider future capital expenditures necessary to continue the operations of each respective business. Due diligence might reveal that industry trends are leading these companies to require a $300,000 piece of equipment by June 2015. Company B made the investment in this piece of equipment in 2014, while the management of Company A decided to push this investment until the last minute. Although each expects annual maintenance capital expenditures of approximately $50,000, Company A has an immediate expenditure that must be considered.
Pitfall No. 3: Company A maintains only $100,000 of working capital, much less than others in the industry. Company A’s management has utilized a “timing” strategy for its payables that has allowed it to maintain a lower amount of working capital, but any hiccup could result in a liquidity problem for the company. Company B, on the other hand, maintains working capital of $400,000, which is an appropriate level of working capital based on industry ratios and the company’s annual revenue of $5 million. Based on industry ratios, Company A may have a working capital deficit of $460,000.2
An investment in Company A at an EBITDA multiple of fi ve will result in an additional investment of $760,000 for capital expenditures and working capital, whereas no such additional investments will be required for Company B. The result: the investment in Company B at a multiple of fi ve times EBITDA will produce a greater rate of return than an investment in Company A at the same multiple of EBITDA.
1 EBITDA multiples are not derived when negotiating the transaction, but are rather the result of a math exercise following the completion of the transaction. Educated buyers evaluate businesses based upon comparable rates of return.
2 Assumes a 12.5 sales-to-working-capital ratio.