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| Why Don’t You Gentlemen Use EBITDA?
Question: Many books on business valuations use EBITDA in their calculations. I notice that you gentlemen treat Depreciation and Interest as legitimate expenses as opposed to crediting them towards “owner’s discretionary income.” Can you explain? Thanks. Answer: While EBITDA has some benefits as a method for making comparisons among companies, it doesn’t seem to be very effective in helping a buyer or a seller arrive at a fair business valuation.EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) came into prominence in the 1980s as leveraged buyout investors looked at distressed companies that needed financial restructuring. They used EBITDA in order to quickly calculate whether these companies could pay back the interest on these financial deals. EBITDA spread to a wide range of businesses and also became a good tool for evaluators, when comparing various companies.Unfortunately, while EBITDA may be a very useful tool for estimating short-term cash flow and for comparing similar companies in an industry, the method is very questionable when trying to determine the value of a given print shop or many other types of companies.In valuing a print shop while using EBITDA, the primary problems have to do with the expense items of “depreciation” and “interest”. Someone using EBITDA in their valuation technique will NOT count “depreciation” and “interest” as costs of doing business. They argue that “depreciation” does not affect cash flow and “interest” may or may not be a required expense for the new owner. While there might be some logic to using EBITDA when there is no history to back up the typical industry cost for “depreciation” and “interest,” this is not the case in the print-for-pay business. We have records going all the way back to the mid 1980s. Back then, depreciation ran about 4.5% to 5% of sales volume and interest ran 1.5% to 2.0%. As copier leasing became more popular in the last 20 years, depreciation has declined to a little under 3.5% and interest has dropped to about 1% of sales volume. The important point to keep in mind here is that “depreciation” and “interest” are REAL COSTS of running a print-for-pay business. At this time, the real cost in our industry is about 4.5% of sales (depreciation is 3.5% and interest is 1.0%). Eliminating them from the expense list only clouds the ability to value a company. Printing companies use equipment to produce sales. Some of this equipment is purchased and depreciated. The depreciation expense and interest expense are necessary to write off the cost of this equipment and build a reserve for future purchases. Another very important point to keep in mind is that valuation formulas that use EBITDA as a component also tend to use a lower multiple in arriving at the final value of the business. A common multiplier of EBITDA is about 2.5 to 3.0 times. In other formulas, which include depreciation and interest as true expenses, it is common to have a multiplier of 4.0 to 5.0 times. When these different multipliers are taken into account, the final valuation calculations are often very similar. In summary, while many appraisers will use a formula based on EBITDA as one of several methods for valuing a business, it does not seem to be one of the better methods in an industry like print-for-pay, where there is significant history about specific average industry costs. A much better method is to base the valuation on some multiplier of actual company profits after considering all of the expenses involved in running the business. DEPRECIATION & CASH FLOW Question: A reader asks, “Since you don’t consider depreciation as part of available cash flow, aren’t your valuations always going to be less than methods that use a multiplier of EBITDA or ACF? Answer: Not necessarily. You are right, we treat depreciation and interest costs as real expenses and believe they should be treated as such, but that doesn’t necessarily mean that by using our formula you will come up with a lower value. Remember, almost all valuation methods rely on the use of some multiplier which is then applied against either adjusted cash flow (ACF), earnings before interest, taxes, depreciation and amortization (EBITDA) or in our case excess earnings. What is unique about our valuation approach is the fact that we have determined a precise method for calculating our multiplier, while other methods end up by suggesting a multiplier range of 1.5 to 4 or even higher. That certainly isn’t much of a help considering the broad range of valuations such a multiplier will produce. Knowing the intrinsic value of many printing businesses in our industry, especially the ultimate selling price of many, we worked backwards to develop a very precise valuation questionnaire consisting of 14 questions, each of which is weighted separately. The average arrived at after answering the 14 questions produces a precise multiplier. So to answer your question, while we choose not to include depreciation and interest in calculating our “excess earnings,” our multiplier is often higher than is used in other valuation methods. The end result is that both methods may produce very similar valuations. The only difference is that the answers to our questionnaire stand as the basis and justification for the multiplier being used, while other valuation methods make little if any effort to justify or explain why they would use one multiplier as opposed to another. In fact, in many cases, valuation methods that cite a multiplier range of say 1.5 to 3, or 2 to 4, often leave the buyers and sellers no better off than before since that range of multipliers often translates into differences in selling prices ranging between $100,000 and $300,000 or even more. By using our valuation questionnaire, we help both buyers and sellers arrive at a much more precise multiplier and thus a much more precise valuation. CAN LEASE PAYMENTS RECEIVED BY OWNER BE CONSIDERED PART OF OWNER’S COMPENSATION? Answer: This question pops up often in our mailbox. For various reasons, owners choose to personally buy equipment and then lease it back to the company, and the monthly charge is often more than would have been charged by an outside leasing company. In the situation described above, a large portion of the lease payment (from the business to the owner) is nothing more than a return of the owner’s capital that he used in buying this equipment and a reasonable return on that capital. The total of these two items should NOT be considered part of owner’s compensation. The part that should be considered owner’s compensation is the excess interest (3% higher rate) that was charged. Let’s look at an example of a $60,000 copier that was purchased personally by an owner and leased to his company for $1,350 (about 3 percentage points higher than current rates) per month over a 60-month lease. In the first year of this example, approximately $15,120 would be a return of principle and standard interest to the owner and would not be considered owner’s compensation. The additional $1,080 is excess interest and could be considered a part of owner’s compensation. Unfortunately, many printers don’t consider that they had to use their personal cash to buy this copier and they end up counting the entire $16,200 ($1,320 x 12 months) as owner’s compensation. This can lead to a false sense of profitability in their total operation. PRINTER PAYS NO RENT ON BUILDING HE OWNS Answer: The cost to operate in a business location is a normal expense and should definitely be included on a company’s profit and loss statement. When the occupant does not own the building, this cost is simply recorded as “rent”. It gets complicated when the occupant owns the business location and he chooses not to charge the business any rent or comes up with something other than a fair market rent number. Simply put, the accountant is correct. If “rent” is not listed on the P&L as an expense, then the company will show higher profits and therefore will appear to be worth more than it really is. That is also true of the owner’s salary. This owner indicated that he took out a “regular, pretty good salary”. I’m not sure what that means. It could be 6% of sales or 20% of sales. To solve both of these problems, in our book “Print Shop For Sale”, we discuss how to make adjustments to a cost item when it falls out of the norm. For example, in our industry, building rent tends to cost a little less than 5% of sales. So, if we were advising a buyer of the above business, we would suggest that they add in 5% as a building rent cost number in calculating the real profits of the company. We also cover a formula for the payroll value of an owner. This formula could be compared to what this owner paid himself to see if this cost is in line. Both of these adjustments could be made prior to determining the value of this company. HOW TO HANDLE ONGOING LEASE PAYMENTS Answer: First, while the final selling price CAN be based on a balance sheet with no debts, it doesn’t have to be that way. It could also be based on the buyer assuming many of the debts of the business. Deciding which assets and liabilities will be included in the sale is all part of the process of arriving at the final selling price. In the book, we discuss how the buyer and seller can handle the transfer of assets such as Accounts Receivable or Inventory and also how they would treat debt items such as Accounts Payable or other liabilities that are transferred with the sale. As for the handling of future lease payments, these are typically considered an ongoing expense of the business and would be paid by the buyer in future years as they are incurred. In the printing industry, most leases are Fair Market Value (FMV) leases, which call for a set number of monthly payments and then a buyout amount at the end to purchase the equipment. Effectively, until the buyout is made, the equipment is being rented with a commitment for a certain period of time. Because this equipment is not owned by the seller, the value of the machine is not charged to the buyer at the time of the sale and therefore the ongoing payments are the obligation of the buyer. While the above process makes good sense for both buyer and seller, a complication often arises if the equipment has declined in value much faster than indicated by the lease payment schedule. If this occurs, then an adjustment can be made to the selling price of the business to account for this variation. For example, a $50,000 copier would typically lease for about $1,000 per month, over a 60-month lease, and then have a FMV buyout at the end. At the end of 36 months, there would still be 24 months of payments remaining, at $1,000 each, plus a probable FMV buyout of about $7,500. This would mean that the amount owed would be about $31,500. But, it would not be surprising to find that this copier would only be worth $10,000 to $15,000 at the end of 36 months. If this were the case, then the buyer would be justified in asking for an adjustment to the purchase price to account for this difference. HOW TO HANDLE COPIER LEASES Answer: While the tremendous variance between the real lease payment ($1,820) and the expected lease payment ($800) is out of the ordinary, the fact that there is a variance is quite common. This typically happens when users upgrade equipment while they still owe money on their existing equipment. In this case, the selling company probably owed a very large sum on previous leases and that money was simply rolled into this new lease. While this is money owed by the seller for past equipment upgrades, it is certainly not money that should be paid by the buyer. Unfortunately, an unsuspecting buyer could get trapped into taking over this lease and paying far too much for this copier. In this situation, my recommendation to the buyer was as follows: Assuming he is willing to include the Canon iR7105 as part of the business purchase, he should figure his cost as $800 per month for 48 months. The additional cost $48,960 (48 payments x $1,020 extra per month) should be deducted from the final purchase price of the business. MARKET VALUE VS. LOANS & CAPITAL LEASES Answer: In the chapter on Net Assets, we talk about the MARKET value of equipment at the time of sale. No matter what the original purchase price or the book value shown on the company balance sheet, a buyer will want to pay what the machine is worth in the market. Also shown are liability items such as Notes Payable and Other Liabilities. Typically, the outstanding loan balance will be found in one of these line items. An example should show how this equipment and loan balance would be factored into the final sale price: A seller buys a piece of equipment for $50,000 and takes out a loan for $45,000. After two years, he decides to sell the business. At this point, the equipment is appraised at $25,000 and the remaining balance on the loan is $32,000. If both the equipment and the outstanding loan are left in the sale, it will have a $7,000 negative affect on the value of the Net Assets ($25,000 asset minus $32,000 owed). OFFERING TO PURCHASE CUSTOMER FILES Answer: I think there are a couple of ways to proceed. First, I would suggest that this seller be given a copy of “Print Shop For Sale” to read. In particular he needs to be directed to the section on common Rules of Thumb where it explains how businesses are often erroneously valued based on some relationship to sales volume. That “Bad” Rule of Thumb is probably giving this owner a false hope that he can get a high value for his shop. Along with the book copy, I would suggest that this owner be given a simple one-page valuation form where his company is valued based on material presented in the book. Reality may need to set in for this seller. When there are no bidders for his business for 3 to 6 months, he may then realize that it is overpriced. At the same time that these things are happening, I would suggest that this buying printer put together his proposal to purchase the customer files. This offer may start to sound a lot better as time passes. How to contact the authors: Larry Hunt, Larry Hunt Publications, Inc.
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