EBITDA Normalization Adjustments: Where do you stop?
For public companies the most noted multiple is that of after tax net income (a PE multiple). For early stage companies it is quite often a multiple of revenues because, either they are not profitable or, they are in a high growth phase, where profit levels are depressed as a result of higher than average spending on R&D and product/service marketing. For established private companies, the most commonly cited valuation metric is a multiple of EBITDA.
Why use EBITDA?
EBITDA stands for Earnings Before Interest, Taxes and Depreciation and it allows for comparison of profitability by canceling the effects of different asset bases (by cancelling depreciation), different takeover histories (by cancelling amortization often stemming from goodwill), effects due to different tax structures as well as the effects of different capital structures (by cancelling interest payments). Therefore, an EBITDA multiple is the most comparable multiple for assessing free cash-flow of an unlevered business. The drawbacks of using EBITDA are that it doesn’t account for maintenance/required capital expenditures (CAPEX) to sustain the business and, because it is a non-GAAP metric, it is often presented on an adjusted basis excluding (sometimes questionable) one-time items thereby boosting profitability.
Be careful when comparing EBITDA across different industries
The relationship of an EBITDA multiple to other multiples can vary widely across industries. For consulting or software companies, that typically don’t or can’t carry long term debt and have little investment in fixed assets, EBITDA is often the same as earnings before tax. For capital intensive companies, an EBITDA multiple of five might be the equivalent to an EBIT multiple of seven. When we speak of a five times EBITDA multiple for a private company, the value may actually be the same as 15 or 20 times net income after tax for a profitable public company.
A multiple of when?
The period the multiple applies to is also important. While valuation is conceptually a forward looking principle, the standard is to use a historical multiple as a proxy because of the difficulty of predicting what the next 12 months of earnings might be. Some variants of time frames used are “run-rate” (annualizing the last month or quarter), “latest twelve months” (LTM, typically calculated on a rolling four quarters basis), or last calendar or fiscal year. Why does the timeframe matter? Let’s look at a fast growing public company such as Apple. On August 20th, its market cap was approximately $620 billion. Its latest fiscal year ending (EBITDA was $35.5 billion and its 12 month consensus forecast EBITDA was $55.8 billion. People will say Apple is trading at 17.5 times EBITDA but the more proper metric is that it is trading at 10.7 times forecast EBITDA, a difference of 70%.
Adjusted EBITDA is becoming a more common term for public companies. Companies are reporting adjusted EBITDA to convince analysts that reported income contains a number of one-time items that they should not be concerned about. While controversial for public companies, “normalization adjustments” have always been a practice in the private company sales process, largely because private companies typically incur more discretionary expenses.
The idea behind adjusted EBITDA is to present a number that a buyer can reasonably expect going forward. Profitable private companies will try to minimize their taxes payable. This is simply good business practice. However, one must be reasonable; for example, the spouse of an entrepreneur is paid $100,000 per annum for bookkeeping services. In a small company that may be overpaying him/her and it may just be an approach to lowering household personal income tax; whereas, if he/she were to be an accredited accountant in a large company, it may even be underpaying him or her. The tax authorities apply reasonability tests; the latter is reasonable, the former may not be. Since tax minimization usually results in lower income (and therefore lower income tax payable); the adjustments will increase EBITDA and thereby provide the basis for a higher valuation of the company.
Common normalization adjustments to arrive at adjusted EBITDA
Adjustments are generally made for one-time events, discontinued parts of the business (or parts that are not being sold) and ongoing expenses that are either not necessary to run the business or not at market pricing. Some examples of one-time items include start-up costs, certain product development/deployment costs, costs associated with new legislation or regulations, and lawsuits. Ongoing expenses may include superfluous expenses such as luxury cars, boats and planes, summer homes expensed as regional offices, payments to family members not fully engaged in the business or at rates above the market rate, business trips that are really/mostly family vacations, personal tax and legal advise and personal bonuses or dividends that would be at the new owner’s discretion. Conversely, when times are tough, entrepreneurs may pay themselves less thereby smoothing the impact of volatile revenues. Entrepreneurs may wish to exclude bad debts or legal fees that they feel are excessive but in most cases these are recurring and necessary business expenses and therefore should not be eliminated.
Too many is a red flag
Normalization adjustments are a delicate matter. Too many and it becomes a red flag, raising concerns such as, “what are they trying to get away with here?” or, “with so many adjustments, does this reflect poor customer/supplier relationships? or, “there is probably more to it than that, I wonder what they are not telling me?”. If your adjustments are not viewed as legitimate you lose a tremendous amount of credibility and negotiating power. Also, what normalization adjustment should not do is make assumptions about a particular buyer and suggest that the business can run without certain expenses that a particular buyer might not incur. This is the value to a buyer that you can point out in discussions but a buyer will rarely pay for improved prospects that it can bring to the table unless it is forced there by way of a competitive auction.
So far we have talked about adjusted EBITDA because it is the main value driver, but we must also look at the balance sheet. The company’s competitive position and economic prospects drive the valuation but then a balance sheet that is different from what is expected/required will result in adjustments to this valuation. Redundant assets should be stripped and, on the other hand, if productive assets need to be replaced then adjustments may be required that have a negative impact on valuation.
EBITDA is just one factor of many
Finally, in addition to the specifics of the multiple, there are many bigger picture questions with respect to the valuation of a transaction such as: did the buyer assume the debt; were there working capital adjustments; was the amount paid in cash on closing or will it be paid over time? Different answers to these questions will also measurably impact the net multiple paid. So the next time someone tells you they sold their business for a great multiple, think about a multiple of what and when.
Recommended further reading
For more on Goodwill (business vs. personal), see: Business Goodwill Transferability is Critical for a Successful Business Sale
For more on the various stages of a sale process, see: What are the Steps in Selling a Business?