The Art And Science Of EBITDA Valuation
“So there is no set formula. It’s only a guess!”
A young man exclaimed this after asking me a question the other day. Largely, he is correct.
While grounded in hard numbers, the business of valuing, buying, and selling companies is still very much an art as opposed to a science. This IT professional was a bit mystified as to how those hard numbers translated exactly into the offer that had been given to the owner of the construction equipment rental firm for which he worked.
The owner reported that he should have had a better offer - saying that a multiple of 3X EBITDA was, at current fair market values, entirely too low. The young man, knowing that I buy and sell businesses as my bread and butter, asked me to shed light on the whole process.
Without risking sounding misleading towards many business owners and entrepreneurs who are pondering a tentative query to one of those ubiquitous “Are you interested in selling?” letters they get with regularity, let me explain what I told my young colleague.
A good starting point for the valuation of a company is its EBITDA (earnings before interest, tax, depreciation, and amortization). EBITDA is calculated by adding non-cash expenses of depreciation and amortization back into revenue that includes all income and expenses, with the exception of interest expenses and income tax expenses. This gives a picture of a company’s profitability as it might compare to similar companies across many industries. In this sense, a general purchase value of a company can be determined as a multiple of EBITDA, typically somewhere between 2-4 times that number for non-tech, sub-$20M revenue companies.
This initial picture of financial performance, of course, must be balanced in a few ways. First, it does not measure cash flow. Even while the initial numbers look great, potential buyers and investors will ask hard questions about the working capital ratio. EBIDTA also does not offer an accounting of actual growth potential or such intangible assets as customer base or specialized knowledge. Buyers will evaluate such factors, in addition to the other numbers that do not necessarily show up in the EBITDA: discrete assets and liabilities, revenues, different earnings breakdowns and external industry market factors.
Through a bit more conversation, the IT professional stated that they were well in the black, but admitted that they had gone through three controllers in two years. The owner’s son had designed and been twiddling with a project management app for the past 18 months, and it worked fine, although it did require some work-arounds.
Hearing this, I guessed that the offer was still right on target with fair market value trends. Had the project management app been developed commercially, the offer might have been higher, as tech assets are higher in value these days. However, that unrealized potential was likely impacted because the financial records were potentially in some disarray. In this case, the business owner’s offer might have been better had he been able to provide exacting financial records so that those asking could get the most accurate picture of their quarry.
According to the BVR Resources 3rd quarter Stats Brief, the buyer’s offer of 3 was probably quite fair. As an industry whole, most services businesses are garnering offerings between 2.5 and 4.0. In the end, this seller had not maximized what he could have in order to convince buyers that their ROI would be any higher. The numbers – the science - looked good from the start, but the intangibles – the art – told a different story.
