Let’s talk about EBITDA. A few questions and answers.
Question: What is EBITDA?
Answer: Earnings before Interest, Taxes, Depreciation, and Amortization.
EBITDA is widely used and is easy to calculate by taking income from operations (reported in the income statement) and adding back depreciation expense and amortization. It is the “go to” metric in the business community for companies with revenues of more than $1 million annually.
Question: Why do companies use Adjusted EBITDA as a starting point for an estimate of the value of a company?
Short Answer: Because buyers use it. EBITDA is often used as a valuation multiple in the landscape industry and in other industries that need a metric to calculate and compare the value of privately held companies. This is for a quick estimate of value. Note that another value may be requested from a qualified appraiser who would calculate a Fair Market Value based on Revenue Ruling 59-60 and/or other standards such as state law, case law, etc.
Longer Answer: Other than Brightview, most landscaping companies in the US are privately held, small (compared to the average publicly held business) and don’t want or need to be listed on a public stock exchange. Being privately owned has its advantages for owners, especially now that there is sufficient capital in the private marketplace to attract interest from private equity funds. Landscape business owners can access private capital as investors in their businesses in order to scale their businesses. Most of these private companies do not have to report their results in accordance with any authority. Keep in mind that the NYSE or the NASDAQ has requirements that listed companies provide their information in accordance with Generally Accepted Accounting Principles. (GAAP) Even with those guidelines, there is room for interpretation for companies listed on a stock exchange.
While many privately owned businesses will have their financial results prepared based on GAAP most won’t have audited financial statements and even if they do, there is no market force driving them to regularly report on their performance. That is one of the benefits of being privately owned! A public company must perform according to standards expected by the market and the analysts for their segment. The relentless pressure of delivering what the market wants every quarter can create a short-term focus among management.
Values often fluctuate for privately owned businesses since the marketplace does not have a standardized way to report financial information that will allow investors to judge the value of the company. There are some records that have been kept over the past few decades, but other than the Small Business Administration, these are self-reporting collections of information gathered by advisors. There is no quality control for the entry of the information or even agreement among the parties about what and whether certain elements should be shared. So, for example, only partial information may be shared about a sale, it may be wrong, and it might be hard to interpret.
When the entity is privately held and market prices do not exist, it is necessary to have a way to calculate a company’s value based on other facts. Companies used to use EBIT which stands for earnings before interest and taxes. (Earnings is another name for profit). EBIT is gross profit minus operating expenses, including depreciation and amortization. Note that this is before interest and taxes are subtracted from the revenue because operating profit is the profit earned from the business, not from taxes or interest. Taxes and interest don’t have anything to do with the profitability of the operations of the company. EBIT used to be the number investors would look at to see how well the operating part of the company was being run.
Because some of the companies on Wall Street turned out to have committed fraud in their reporting to make it look like they had better profits than they did by changing the depreciation assumptions, rather than by generating operating profits, Wall Street started looking at the EBITDA numbers. It showed the operating profit before interest, taxes, depreciation, and amortization and ignored non-cash charges.
Most private companies are non-tax paying flow-through entities, like S corporations or LLCs. Since there are differences in individual tax rates that would be difficult to reconcile, the valuator will use the pre-tax number for estimates.
Further, the EBITDA will be adjusted to reflect charges to the income statement that are owner-related discretionary items, most of which are adopted to limit taxes. These include:
- Owner-related discretionary items
- Employee related items
- One-time expenses
- Discretionary business practices
Then, you can add interest expense and noncash charges.
VOILA! You should now have a recast EBITDA number to use for valuation purposes. The EBITDA number is usually substantially higher than the reported pretax profits.
Keep in mind, though, that EBITDA does not equal cash flow. We will cover free cash flow as another way to compare company performance in a future blog post.
If you’d like to discuss EBITDA and how you might arrive at your adjusted EBITDA number, feel free to give us a call. It’s never too early to start working to understand how your business might be valued depending on the reason for the valuation and the facts at the time of the valuation. Do you want to think through your options for exiting your business? Give us a call. We help companies prepare for and execute their plans for now and for the future. Working with a trusted advisor can leverage your time.
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