It is common to hear from broker/intermediaries: “That business is worth 3 times earnings“. In my part I post, I talked about the very basics of what “earnings” are. I’ll expand a little on this here and then in part III I’ll talk about the “3 times” part of the equation.
I mentioned in a previous post that what really matters is future cash flow, so the earnings used should at least resemble the cash flow, not an accounting definition of earnings. Thus taxes, depreciation and amortization are deducted. Some now believe that taxes should be included, but for smaller companies that doesn’t make sense since many employ such varying degree of “tax minimization strategies”, if you know what I mean. In addition, interest payments depend greatly on the debt structure of the owners. So to be able to compare companies, we also deduct interest payments. That is where the EBITDA that you probably hear about comes from. Earnings Before Interest, Taxes, Depreciation and Amortization.
However, small/mid size businesses (SMB) are often managed by the owner, and its hard to calculate a true EBITDA number since many times it would be zero after the owner takes his share. Plus, as we all know, there are many benefits to owning a small company, such as hefty 401K contributions by the owners, health benefits, and of course the stuff we don’t talk much about like personal cars and that condo in Hawaii. For SMBs we try to account for all “owner benefit” and this is what Discretionary Earnings are (DE, also called Seller’s Discretionary Earnings or Seller’s Discretionary Cash Flow). It is the earnings of the company, adjusted for ITDA like EBITDA, then adjusted for one owner’s salary and all of “owner’s benefit” (the perks).
It is important to realize that DE does not equal EBITDA. It is common to hear from business owners, “I have been told that my business should be worth 5 times earnings”. If his company has a DE of $300,000, that would be a value of $1.5M. The EBITDA of that business, assuming it would take a manager at $100,000 per year to replace the owner, would be $200,000, which would mean a value of $1M at 5 times. There is a big difference.
Investors, like private equity groups and VCs, tend to think in terms of EBITDA. That makes sense since they will hire a manager (or the former owner) to run the business, and they are interested in what is left over to pay the investor a return on his investment.
Private owner/operator buyers tend to think of DE. What are the total earnings of the business? They then can deduct debt payments and come up with what they will end up with as a living wage and return on investment.
Generally, small companies use DE, large ones EBITDA and ones in the middle with earnings measured in hundreds of thousands can go either way so you have to pay attention on those.