Basics of Valuation Multiples
If you have contemplated the idea of selling your business, or even if you have not, you may have come across the concept of valuation multiples. For instance, a business might be valued at 6 times EBITDA or perhaps 5.5 times SDA. Are these figures equivalent? Is it possible to make a comparison between them? Not necessarily.
Firstly, let us clarify the meanings of these terms:
EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is quite straightforward. It begins with net income and incorporates the aforementioned elements, with 'taxes' specifically referring to income tax.
SDA, or Seller’s Discretionary Earnings, not only includes all the components of EBITDA but also accounts for additional items viewed as compensation for the owner, or benefits that a prospective new owner might not possess. This encompasses the owner's salary, health insurance, automobile costs, travel expenses, and various perks.
Here’s a hypothetical example comparing the two methods side by side with a normal income statement:
For the purpose of this example, we will assume that the officer's salary and benefits constituted a fair compensation, and that ABC company was sold for 1.5 million dollars. (Any amounts deemed unreasonable must be adjusted to reflect what a buyer would typically pay for similar items, such as rent or salaries.)
Here are the ratios:
Price to Sales = 1,500,000/2,000,000 = .75
Price to EBITA = 1,500,000/717,000 = 2.09
Price to SDA = 1,500,000/947,000 = 1.58
It is essential for both buyers and sellers to recognize that each company possesses distinct characteristics, necessitating an understanding of the factors contributing to its financial figures. Interest is reinstated as the buyer may not inherit the existing debt, yet they will probably have their own financial obligations, which must be evaluated for cash flow viability. Additionally, depreciation and amortization are factored back in since they do not involve actual cash disbursements. This adjustment does not indicate the age or condition of the equipment, nor does it account for potential future expenditures.
Sellers' discretionary earnings aim to address the issue that owners' compensation is not consistently applied between businesses. In many instances, particularly with S corporations, their compensation may fall below market rates, while in C corporations, it may exceed them. Additionally, perks can either represent genuine business expenses or be a form of owners' compensation disguised as such, particularly in the case of vehicle expenses. I have encountered owners with a range of vehicles, from those driving old, nearly worthless pickups to one individual who owned a brand-new Mercedes with no business use, and everything in between.
In conclusion, it is essential to identify the ratio being utilized and to examine the specific 'discretionary' expenses to determine what qualifies as truly discretionary. The process of modifying financial statements to account for discretionary items (or transactions that are not conducted at arm's length) is referred to as normalizing or normalization adjustments. Obtaining the most precise estimate of the future benefits that a buyer can anticipate from the company aids both the buyer and seller in reaching a fair price.