Why is EBITDA Important in the Game
Or is it just a big lie? The universe of buyers make money for their investors by buying businesses and creating value. Implementing changes to improve top-line revenue, e.g. growth and expansion into other markets, and operating efficiency, e.g. changing manufacturing processes, using high tech machines, etc.. It’s about making a company much better than it was before an acquisition; all of which impact EBITDA. Some “experts” claim when valuing a business using EBITDA multiples, “you’re already losing! EBITDA is a bullshit number.” It’s the best metric we have at the moment in analyzing private companies. However, it’s not the only metric.
Recently, we met with a business owner of a niche manufacturing company who proudly exclaimed his company was worth $15MM. “We’re at $2MM EBITDA, and with a 7X multiple…” We called timeout… for an education minute. Charlie Munger famously said, “I think that every time you see the word EBITDA, you should substitute it for the word bullshit earnings.” Munger always argued depreciation is a real cost to a business and to a degree he is absolutely correct. EBITDA does ignore:
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Depreciation
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Equipment Replacement Costs
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Real debt costs, and
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Tax Obligations
Oftentimes, we have to back out one-time charges et al to get a realistic picture of earning and create an “Adjusted EBITDA”. Some will continue the argument, saying ‘…[it’s] basically making up numbers to suit the story.’ and that too is partially accurate. Our business owner, Mr. George, likes to run some of his personal expenses through his business…and leading up to a sale es no bueno.
The Truth
“Your business is worth what someone is willing to pay for it. Nothing more.”
Different buyers will use different methods as different buyers have different criteria. It’s all different! As your advisors, what we are looking for is how healthy or profitable is the business – gross profit, net profit, net operating margin, free cash flow. Everyone in the game has a model and a method to determine the valuation multiple. What Mr. George assumed is since the average multiple in his sector is 7X, by all means he should get 7X. However, should is never to be used in business of any kind! Factors that influence multiples in addition to comps and sector/segment history include:
- Management Strength – 3rd party professional leadership team capable of implementing and executing strategy
- Diversified Customer Concentration – no one customer occupies more than 20-25% share of revenue*
- Annual Recurring Revenue – predictable subscription based revenue quantifies growth and forecasts revenue
- Fragmented Segment – typically many small players, allow for consolidation leading to increased market share and operational efficiencies
- Margin Expansion – implementing operational improvements, optimizing pricing strategies, enhancing sales effectiveness, and pursuing product innovation
With the above in mind, Mr. George has a number of issues eroding his assumed multiple. All decisions go through Mr. George even though he does has a decent #2. His customer concentration is a bit high at 30% and he can easily remedy this and increase revenue by adding one or two sales makers. His ARR is pretty good and in adding two salespeople will increase even more. His sector is a private equity darling which also led to his enthusiastic multiple. If Mr. George decides to hire JSP, then there’s a tremendous upside to improving his margins leading up to a sales process where he may recoup what he’s lost.
What happened to the $15MM valuation?
When we drilled down to actual net profit before tax of $700K, the true value of that business was no more than $1.2MM. This is what we call a +$13 million reality gap! All this time could have been avoided by taking advantage of a Value Gap Analysis (VGA) before a process. The business is asset heavy to meet capacity and throughout goals. Future growth requires the company to invest in and update equipment and technologies to achieve yearly targeted production metrics. This is also known as a space-race where one competitor is always one-upping the next.
