Ok, so maybe that’s not the most professional way to title a blog… We can discuss that another time.
In the last blog we discussed the 2 main criteria a bank looks at for approving a commercial (and theoretically personal) loan.
- Cash Flow – do you make enough money to afford the payments?
- Tangible Assets – if you don’t make enough money what can we sell to pay off what you owe us?
Since that blog was written a banker educated me concerning listing revenue and a customer list as an asset “There is no way to assign a value because that customer base can decide to go away on a moment’s notice. They are not required to do business with you. So that value in the business is actually a part of the “blue sky.”” So you know I’m not making this stuff up. To think that customers are just going to disappear when, on average, each one has been with you over 8 years AND new customers are going to stop buying from you when you’ve had a successful revenue generating strategy in place for nearly 40 years is kinda silly. For most people their business’ are their lives. With that kind of track record how/why in the world would they all of a sudden sabotage it. That just seems like a ridiculously minor risk.
Does anyone know if banks are “forced” to not consider revenue or customer base as an asset because of some strange banking or FDIC regulations?
At any rate, we’ve spent enough time on valuing a business based on tangible assets so let’s consider valuing a business based on EBITDA. Firstly, EBITDA and cashflow are NOT the same thing. If you’re buying a business, you should always value it by looking at profits. Secondly, EBITDA in no way approximates or represents profits. I only point that out because if you’re trying to buy a business and someone tells you that it’s worth $1 million because EBITDA is $200k and the standard multiplier is 5 then you should indicate that EBITDA doesn’t tell you anything about the business and you need to look at profits instead. Let’s look at each piece piece of EBITDA so we can see why its only helpful when you sell your business (because it’ll drastically inflate the business’ value).
- Earnings – depending on who’s doing the evaluation this can be either Net Operating Income or Net Income. In essence, this is your “book” profits. Except there’s one problem. If your business is based on Accrual accounting (which over 95% are) then earnings are based on sales, not on deposits. Just because I made a $1000 sale, doesn’t mean I’ve actually collected $1000 and have that cash in my bank account to spend. In other words, this tells me what earnings should be but not how much of that is cash in my pocket.
- Interest – The theory goes that when you buy a business you’re not buying the business’ debt so you have to pull out its interest. That makes sense as long as you add back in the interest you’ll now be paying for whatever loan you need. If you’re just using EBITDA to measure “free cashflow” in a public company, you definitely don’t want to pull out interest because they have to pay that every month and that certainly affects their cashflow.
- Depreciation – The basic idea is that if you buy a truck, car, building, computer, or office equipment for your business, you can’t write-off that expense all at once and so have to depreciate it over 3,5,7, or 21 years depending on what it is. Well you had to pay for it upfront, so now you have a non-cash expense (i.e. an expense that shows up on your income statement that isn’t a part of payables) and more cash in your pocket every month, right? There are 2 problems with that.
- You generally still have mortgage or car payments to make that don’t show up on your Income Statement. So in this instance some portion of that depreciation IS actually decreasing your cash flow every month.
- Depreciation is designed to expense an item over it’s lifetime. However, at some point you’ll have to replace that item again. If its your habit to pay for everything up front without a loan then every month you’ll have to be setting some cash aside to replace that item when its useful life expires.
- Taxes – This one is similar to Interest in that when you buy the business you’ll have a new accountant and and so the amount you pay in taxes is going to be different. That sounds reasonable to me. So figure out how much in taxes your super-accountant will be able to save you and subtract that. Don’t just assume taxes are going to disappear and base your business valuation on that assumption. One way or another you will pay taxes – or end up like Al Capone.
- Amortization – The whole concept of amortization is probably the one I understand the least but here’s my explanation anyway. Admittedly, this one can be a very legitimate non-cash expense. I’ve discussed this one with business owners, accountants, lawyers, and bankers and, though they all seem to have a slightly different explanation, from what I can tell, it’s a GREAT accounting gimmick. Here’s how it works, it’s basically the same as depreciation except for non-tangible assets. For instance, let’s say you pay $1 million for a business but through certain accounting practices you can show the business is worth $600k. You now may have the ability to amortize that $400k “blue sky” asset, that has no “tangible” value, over the next 15-20 years. Now, if you are the one who is making payments on a $1 million loan then the amortization is just like the depreciation. It’s not really a non-cash expense since you’re making loan payments against it. However, if you buy a business where the previous owner was amortizing from his purchase, now you could potentially have 10-15 years left of that non-cash expense to write-off. This is most common when the previous owner bought the business when it was losing money (if you pay any money for a business that is losing money you should have some “blue sky” to amortize) and then made it profitable and sold it to you.
The Bottom Line
EBITDA has it’s place. In fact, it’s great when you want to sell your business. Most people in the business and banking world use EBITDA multiplied by some arbitrary number (generaly 3-9) to come up with the value of a business. Since that value will always be higher than valuing the business based on profitability, then why wouldn’t you try to sell your business based on that?
On the other hand, I’m not sure I can think of one solid business reason to evaluate a business based on an EBITDA, EBITA, or EBIT number. Maybe that’s why EBITDA is not a GAAP (generally approved accounting practice) calculation.
Nonetheless, you have to give it to the first guy who invented EBITDA by highlighting it in a corporate report to show how well his business was doing. We all bought into it and now he even has the banks and accountants using his inventive, creative, and pointless calculation.
Just make sure the next time you’re looking to buy a business or just some stocks, you’re not spending too much time on EBITDA.
To your success, Bryan