Lately it seems like every business owner, seller or buyer I speak with is fixated on EBIT or EBITDA and valuation multiples thereof. They all think “businesses are worth (pick a number) times EBITDA”. Some cite industry norms and others quote multiples from the financial press. Almost everyone concedes that EBITDA levels and multiples are down as a result of the Crash of 2008, but that just confuses things when specifics are discussed. (Will EBITDA come back? Will multiples come back? When
Add to the mix the fact that appraisers talk about net cash flow to equity (NCFE) and (discount rates, capitalization rates and) multiples relative to it, and you have a lot of people talking about two very different metrics: EBITDA and NCFE. Thus the title of this post.
We appraisers know that NCFE is the best measure of expected EQUITY ownership benefits, as it is the cash available for dividends from or reinvestment in the business (for appreciation). We usually base our Income Approach valuations on NCFE, and always base our justification of purchase tests on it.
But others do not always know this, for a lot of reasons which are really not important to this post. Our job has to be to educate them, understanding that they come from an EBITDA perspective.
I like to use a house analogy to start this process, although the Crash of 2008 makes that a little painful. If you own a home that can be sold for $100,000, then that is what the HOUSE is worth. But if you have a $40,000 mortgage, your EQUITY in the house is only $60,000. Even EBITDA advocates agree with this.
When you talk about cash flow to equity from selling that house, your gross sale proceeds are $100,000 and your net proceeds are $60,000. Your cash flow to equity is $60,000. The total amount of capital invested in your home was $100,000, comprised of your equity and the mortgage.
Then I get to the key point. EBITDA relates to the TOTAL AMOUNT OF CAPITAL invested in a business, which is comprised of the stockholders’ equity and the debt owed by the business to banks and other lenders. It’s just like the value of the house, adding both your equity and the mortgage. This is because EBITDA is gross of (does not include deductions for) interest expense and debt principal repayments.
What this means is that if you value a business based on EBITDA, you have to deduct the value of that debt to arrive at the value of the EQUITY in the business, just as you deduct the mortgage from the selling price of the house to arrive at your equity in the house. The value of the equity could be very different from (and much less than) the value of the total capital invested in the business (if it owes a lot of debt). Yes, I know, you add back cash and non-operating assets, but let’s just keep this real simple for now and ignore that stuff.
To make things more confusing, it is possible to sell a business for some multiple of EBITDA and NOT deduct the debt. This happens in a pure asset sale. Now the business seller DOES get that high multiple of EBITDA! And, if the sale is for 100% cash at closing, he or she has a check to prove it!
There is one small detail: the seller has to pay back the debt. This gets them back to equity value. Yes, they sold their house for $100,000, but after they pay back the mortgage, they are left with $60,000 in equity. The same thing happens in an asset sale. You get a big multiple of EBITDA, but you have to pay a chunk of it to the bank.
I would say that many and perhaps most business owners do not intuitively understand the last two paragraphs without explanation, which is a major source of the confusion.
The above is a top-down way of valuing the equity of a business. The bottom-up way is to calculate the net cash flow to equity and discount or capitalize it. The tax-deductibility of interest expense and other factors (like changing working capital requirements) make the calculation of net cash flow to equity (starting with EBITDA) a little complicated for many businesspeople to understand.
I have found that one way to help them understand it is to talk about “cash on cash” return on investment. If you have to put $X of your own money into a business and earn $Y in dividends, then your cash on cash return is Y/X% per year in the simplest sense (ignoring growth, subsequent capital calls, etc.) The $X is your equity, and that does not include any debt you take on (and ultimately have to pay back). The $Y is yours free and clear, and is only available after you have paid all your expenses, including interest and debt principal.
Once they grasp this, and it may take some time (be patient, we are teachers
, they often become much more comfortable with NCFE. THAT is when we can sit down and review detailed financial forecasts with them and get much better feedback.