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Buying and Selling Companies: Is the Price, Right?

You are on the market for a new business, and you think you’ve found the right opportunity. The purchase price is right, the operation seems sound, and it makes money. Is the price right?

 

If you talk to a business broker or an investment banker, you’ll hear about different terms like multiples, discount rates, growth rates, EBITDA, and cash flows. What does this all mean?

 

EBITDA: earnings before income taxes, depreciation, and amortization. EBITDA is an accounting term that refers to profit with add-backs for three items- interest, taxes, depreciation, and amortization. Why is this important? This metric is reflective of the operating profit of the business that can be controlled by operational management. This metric is often used in conjunction with an industry valuation multiple to establish a business valuation, which we’ll describe below.

 

Cash Flow: cash flow is a metric that takes into consideration cash profitability. Since depreciation and amortization is a non-cash impact on profit, those expenses get added back to net income. For cash flow, we also consider that there are cash expenses that affect our cash profitability, such as capital expenditures and changes in working capital (cash provided by short term liabilities subtracted from cash taken my short-term assets). Why is this important? This metric allows visibility into the net cash provided by the company, used to distribute to equity or debt.

 

Here’s a quite simple example:

 

Revenue1,000,000
–        Cost of Goods Sold (COGS)500,000
Gross Profit500,000
  
–        Selling, General & Administrative Expenses200,000
Earnings before Interest, Taxes, Depreciation, and Amortization300,000
–        Depreciation and Amortization20,000
–        Income Tax100,000
Net income excluding interest expenses180,000
Add back: Depreciation and Amortization (non-cash)20,000
Net Operating Profit After Tax200,000
–        Change in Working Capital20,000
–        Capital Expenditures80,000
Cash Flow100,000

 

Mulitple: a multiple is a multiplier rate to show the total enterprise value of a business. Most often, experts use a multiple of EBITDA or cash flows. In high-growth businesses, experts sometimes use a multiple of revenue. Why is this used for valuation? The multiple is a short-hand metric for the value that comes from using the growth rate and discount rate used to generate a lifetime value of the business,’ usually in a metric of profit. How is this established? An industry professional evaluates similar business transactions to understand the relationship between enterprise value and profitability. This is determined by finding the most similar businesses that the industry professional can find by business type, location, customers served, and other business attributes.

 

The valuation expert generates a range of multiples applied to similar businesses,  for example, 3x-5x EBITDA, for the enterprise values. For the example, above, we’d multiply the $300K in EBITDA by the multiple of 3x-5x to value the business at $900K-1,500K for the enterprise value.

 

There are some other factors to consider, such as debt and excess cash, to establish the value of the equity, as debt is assumed, therefore subtracted, and excess cash liquidated from the business.

 

Why would the multiple be 3, and not 5? This comes down to growth and volatility of earnings. If the business is consistently growing, the multiple for value should be on the higher side. Yet, a buyer that sees a major opportunity to grow the business with a new strategy may pay more.

 

What is the business worth? Put simply, it’s worth what someone is willing to pay for it. That should be based on the incremental value that the buyer can extract from the business.

 

Using the methodology above, where the buyer is estimating the total future profit of the business for the price, her price should be the total value that she expects to generate from the business. The value is respective of the cost of capital for the industry and business. Therefore, the firm should have no economic value left for the buyer.

 

Let’s continue with our example:

 

A: Purchase

EBITDA- $300K

Multiple- 5x

Enterprise Value- $1,500

Less: Debt and Excess Cash- $250

Equity Value- $1,250

 

B: Future Operations (discounted by the cost of capital and growth rate)

Total Value of Future Profits- $1,500

Less: Debt and Excess Cash- $250

Equity Value- $1,250

 

Economic Profit: A (Purchase) – B (Future Operations) = $0

 

For the buyer to extract economic value, she must do something to create additional economic value for the business- more revenue or fewer costs. Meaning, the buyer sees that she can make changes in the business to influence the future outcome of profitability.

 

If this is the case, the buyer may be willing to pay more, given this new value created. On the other hand, the buyer may see or feign less future value from the operation, and try to drive the multiple down through negotiations. In each of these scenarios, we create an “ask” from the seller and a “bid” from the buyer.

 

It is critical for each party in a transaction to independently establish their price or respective value in an acquisition-disposition necessitating qualified help from a valuations expert such as a Certified Public Accountant, Chartered Financial Analyst, Investment Bankers, and Lawyers. While the expense of these professionals may be as much as 5% of a transaction, their contributions can determine an actual economic gain or loss in a transaction.

 

 

 

 

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