Wednesday, March 22, 2017

When EBITDA Is Just a Number: The Limitations of EBITDA | Axial

Karen Sibayan | January 20, 2016
Experts agree that EBITDA has limitations and should be taken in the context of other factors in the transaction. Buyers seriously interested in your company will also conduct in-depth due diligence processes to examine your company’s financials over a longer period of time. This is essential for buyers to get a proper assessment of a business’s worth.
“EBITDA is only the starting point and due diligence should result in the discovery of whatever operational issues there are in the financial reporting and EBITDA,” says John Weld, managing director at Strategic Value Advisors.
The due diligence can either happen before or after the letter of intent (LOI). There is no set practice for when due diligence is conducted — many buyers already conduct rigorous due diligence before they submit an LOI or have a more intensive process after the LOI. An M&A advisor can provide you with more information about the due diligence process and timeline.
The norm is for buyers to examine a minimum of three years of financial statements and tax returns — with many of them looking at five years — to determine a target’s profitability trends. “They look at a firm’s tax returns and compare them to its financial accounting reports because these returns may tell something about the business’ expense structure as well as the quality of a company’s profitability that might not be apparent from the financial statements,” Weld says.
Beyond this, buyers will look at a target company’s balance sheet history as a means of discovering existing or potential cash flow issues. “Thus, reported EBITDA is important, but is not, by any means, all that a buyer looks at to determine value of a target,” he says.
Conducting a quality of earnings review by looking at three- to five- years of EBITDA will allow buyers to see whether the metric has gone up or down or if it has shown consistency over that period. This gives a sense of a business’ predictability.
Through due diligence, investors are looking for “growth and an indication of whether a company will continue to grow in the future,” says Adams Price, a managing director at the Forbes M&A Group. “The more important things are consistency and quality of earnings.”
Among other factors, what buyers seek “is EBITDA consistently growing over time,” Price says. “Looking at a longer period of time is always better — certainly a period near an economic cycle, which would give a good indication of performance.” Companies that still had predictable earnings or that had not gone down during the downturn in 2009-2010 are particularly attractive.

The Limitations of EBITDA

EBITDA is a reliable number that the industry cannot ignore. However, investors have to use a variety of measurements when buying a company — including, as demonstrated above, testing for the quality of earnings as part of their due diligence.

“While EBITDA is a good measure especially when comparing investments, it is not a catch-all metric that can completely capture a company’s worth,” says Craig Dickens, founder and CEO of the Merit Harbor Group. “Many owners have become fixated on multiples of earnings or multiples of EBITDA. That can leave significant value on the table.”  This is especially true, he says, as intangibles are increasingly becoming a larger part of a company’s overall value.
Intangibles — non-physical assets like intellectual property (i.e. patents and trademarks) and brand recognition — “are receiving more and greater importance in deals and, ultimately, multiples,” Dickens says. Building a company’s value through intangibles can significantly increase its value over time.
The case of intangibles is clearly a situation where EBITDA plays a smaller part in valuing a company. “Especially at early stages of operations of such companies, EBITDA might not provide a sound basis for determining the real value of the enterprise,” says Strategic Value’s Weld.
The warning here is — “don’t just stop at looking at EBITDA as a proxy for value. Great bankers can help owners monetize the intangibles as well,” Dickens says. “As with many things, the total value of a company cannot be reduced to just one number.”
He encourages acquirers to factor in the following as part of their analysis:
  •   Growth rates
  •   Size
  •   Intangibles
  •   Quality of earnings
  •   Intellectual property
  •   Barriers to entry
  •   Recurring revenue
  •   Customer concentration issues
These are “on par or even more important than EBITDA,” Dickens says. For a business owner considering sale, it’s important to focus on and account for each of these factors of interest.
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For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at Eric@EdisonAvenue.com or 239.738.6227. Also, visit our Edison Avenue website at www.EdisonAvenue.com or my personal website at www.BuySellFLbiz.com.

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