# Business Valuation - In Theory and Practice

## Using Valuation Methods Based on Earnings Before Inertest and Taxes (EBIT)

The multiple of EBIT and EBITDA are often used to value companies. EBIT represents operating earnings before interest and taxes, but after depreciation. This is the difference between EBIT and EBITDA is how depreciation is treated. We advise not to use a multiple approach as your primary valuation method, but rather use this approach (whether on EBIT or EBITDA) as a reasonability test or "gut check" to make sure your valuation using a more formal method such as the capitalization of earnings, capitalization of cash flow, or discounted cash flow make sense.

## Computing

When computing EBIT, with the exception of depreciation, the same adjustments for EBITDA need to be considered, namely adjustments for fair market value rent, shareholder compensation, non recurring revenues and expenses, one time start up costs, one time professional fees, etc. Both calculations remove the debt structure by adding back interest meaning that you are viewing the company as if it had an optimal capital structure, rather than the structure specific for the company under review. This is because it is assumed a corporate buyer will have a stable capital structure with significant borrowing capacity such that the capital structure of the target will look considerably different pre transaction vs. post transaction.

## Multiples

The multiple of EBITDA approach is the more traditional metric used and is often represented in terms of enterprise value i.e. "EV/EBITDA". However, there are some limitations to using EBITDA. The limitations are all based on the fact that EBITDA does not consider the company’s capital expenditure needs to sustain its business, revenue, and earnings. Moreover, if the company has an asset that depletes until fully utilized (i.e. a gravel pit or a mine), EBITDA also may not consider this depletion in its calculation depending on how it is accounted for on the financial statements even though this is a real cost of doing business and ultimately a future cash outlay if the asset is to be replaced. Using EBIT as basis partially alleviates some of these issues, but not without some exceptions to watch for. By deducting depreciation, this takes into account the sustaining capital expenditure needs of the business but only if annual depreciation and sustaining capex are similar.

Often times however, depreciation and capital expenditures are different so this becomes a limiting factor. However, at least with the depreciation subtraction there is an allowance made for capital requirements. Keep in mind that you are looking at what the future potential earnings and capex will be, so taking historical depreciation as a proxy for capex (even if they are basically the same) does not necessarily mean this is correct. You may be better off taking a hybrid calculation being "EBITDA less future capex" which is often used by valuation professionals.

### Reasonability Test

If you are using the multiples approach as a reasonability test, you basically want it as a benchmark against some comparables. Which comparables? Basically, you can use either a public company multiple or a transaction multiple. Remember though that companies are like people, and therefore none are created equal. Companies, even in the same industry, vary in terms of size, customer mix, management, product or service mix, etc. it’s worth repeating that you use a multiple of EBIT or EBITDA as a gut check to your primary valuation method, not as the primary method itself.

## Shortcomings

There are specific shortcomings to using both the public and transaction comparables. With public companies, multiples would typically be higher namely because of the stock’s liquidity. If a stock is more liquid, there should be a premium paid for the ability to sell quickly. Another shortcoming of a public company comparable is the access to information. With a public company, you only have access to information once it has been made public, but before that access is limited which can impact the company’s valuation and its multiple. With a private company, access to information for the parties doing the deal can and should be readily available which would also impact its value and how the multiples ultimately benchmark.

With transaction multiples, the biggest shortcoming is the deal structure itself. No deal is created equal, and the company value can be affected by how much cash was paid, if any shares were issued, if there is vendor take back financing, the existence of an earnout, etc. A second shortcoming is based on who the acquirers are - corporate buyers or financial buyers. Corporate buyers usually work in cash flow improvements driven by revenue increases or cost savings, and this may impact the price paid for the business and consequently the multiple. The quantification and valuation of synergies can be as challenging as the actual business valuation.