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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?
Question:
A Florida printer had a question about calculating his Net
Owner’s Compensation. He wrote: “I personally purchased some
equipment that is being used by my business and I then leased it
back to my company. Every month, my business writes me a check
to cover the lease amount. Should I count this additional income
from my business as part of owner's compensation? P.S. The
interest rate on the lease is about 3% higher than the current
rates being charged by the equipment leasing companies?”
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
Question:
A Texas printer wrote in
with the following question: “I've owned the building, in
which my business is located, for more than 20 years. It is
totally paid for. I don't charge the business any rent and just
take out a regular, pretty good salary. My accountant says I
should be charging the business rent as well as taking out a
salary. He said that by not charging rent it is inflating the
value of the business. Is he correct?”
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
Question:
A Virginia
printer had a question regarding the handling of ongoing lease
payments. He wrote: “I’ve read your book ‘Print Shop For
Sale.' Regarding the business valuation formula, I assume that
the selling price of the business is based on the seller paying
off all of his debts. If this is true, how do lease payments
figure into the scenario?"
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
Question: After reading the new Print Shop For Sale book, a Kentucky printer wrote with the following question: “I am negotiating to buy a printing company in my town in order to merge it with my shop and I have a question regarding a copier lease that they have on their books. It involves a Canon iR7105, which has 48 months remaining on a 60-month lease. Payments are $1,820 per
month. Based on accessories included, the original purchase
price should have been about $40,000. Based on a decent 60-month lease rate, the monthly lease payments should be about $800 and not $1,820. How do I handle this situation?”
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
Question: A California printer had a question regarding loan obligations. He said:
“There are many situations where equipment has been bank financed and the bank holds the security. It could also be a capital lease. How are the equipment value and the loan balance factored into the final sale process?”
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
Question: A New Jersey printer had a question regarding the valuation of a local competitor. He wrote: “I’m in discussions with a local print shop in hopes of buying most of his customer files. I have lots of building space and equipment and so I don’t really want his location. He is trying to sell the business as a going concern, but I believe he is asking far more than it is worth. He is doing about $500,000 in annual sales and has about $100,000 in Net Assets. With Owner’s Compensation of only about $50,000, he is trying to sell the business through a broker for $350,000. I’ve just finished reading your new book “Print Shop For Sale” and have estimated that this on-going business is probably not worth much more than $100,000. If I can determine that he has some good solid customers, I would probably pay him $100,000 or more for his customer files and then he could sell his assets to make additional money from the sale. In this way, he could end up with close to $200,000 from the sale of the pieces. How can I convince him that his asking price is way out of line?”
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:
John Stewart, Q.P. Consulting, Inc.
2110 S. Dairy Road, W.
Melbourne, FL 32904
321-727-2442
FAX 321-727-2166
qkconsult@aol.com
www.quickconsultant.com
Larry Hunt, Larry Hunt Publications, Inc.
P.O. Box 6082,
Palm Harbor, FL 34684
7272-781-7825
FAX 813-854-4005
larryhunt@aol.com
www.larryhunt.com
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