Earnings Multiples – EBITDA, Profit or Earnings?

We all have heard that companies sell on "multiples of earnings." As such, the talk at the country club or trade conference has quickly moved to who sold for the highest multiple. We hear the multiples, but we almost never hear the definition of profit used or important elements such as the deal terms.

The truth is, there is much confusion when it comes to profits and earnings. A recent Wall Street Journal article recognized this fact, stating that there are a "host of names for ... earnings and there is no uniform standard by which to understand them, causing much confusion among investors." Because of this, the definition used should always be clarified.

This article will explain the various types of "profits" used, and the definitions of each. With an understanding of the terms and definitions we can put any particular business sale multiple into proper perspective. To begin, review the most recent year's income statement for XYZ Company that accompanies this article. How much profit did XYZ make? This is a trick question.

Profit comes in many forms. Gross Profit. Operating Profit. Net Profit. Taxable Profit. Earnings can be taken to mean the same as profits. The names and definitions are almost endless. In the box below is a list of commonly used terms that refer to the profitability of a business. Now, you are at your country club and Jack Taylor tells you for the 10^th time this year that he sold his company for 10 times earnings. This time, to his surprise, you ask him what he means by "profits." After he gives you a flip answer like, "You know, the green stuff you put on the table in Vegas," you inquire as to what type of earnings is he referring. He probably doesn't even know himself. But you will. If he sold for 10 times his after-tax profit, then the price was $6,000,000. We see on the accompanying table below that XYZ Co. reported Pre-Tax Profit of $600,000. When we look at the income statement and footnotes, we see that adjusted seller's discretionary cash flow (SDCF) was $3,650,000. Consider this number and the definition of SDCF and you might come to believe that Jack Taylor didn't obtain the premium of which he boasts.

We could estimate, assuming this year was a typical year except for the lawsuit expense and assuming that his company was not a C corporation and thereby subject to double taxation, that this company generates $300,000 in annual after-tax income to the owner. This is pre-debt service and as long as the owner utilized leverage his take-home would be less. Again, it does not appear that he sold for a premium.

In summary, the next time you hear a sale multiple you'll know that it tells us almost nothing unless we know the definition of profit used. Similarly, the sale price is almost meaningless unless you know the terms.

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Business Broker or Merger & Acquisition Advisor? Know the Difference

Who are Their Clients?

Business Brokers:

Business brokers typically represent owners of businesses valued well under $2 million that serve a local clientele. Their clients are often referred to as "main street" businesses. Examples of "main street" businesses are dry cleaner, gas station, convenience store, restaurant, laundry, lawn care, landscaping, nursery, repair shop, beauty shop, individual franchise, and many other business-to-consumer operations with a single location.

Business brokers typically represent businesses that are run by the owner him or herself and no middle management.

Business brokers mainly represent businesses that have little expansion potential.

Business brokers usually work with businesses that resell products made by another (not their own, proprietary products) or are a franchisee or licensee.

Businesses offered by business brokers rarely sell for more than four times proven annual cash flow.

The most likely buyers for main street businesses are individuals that live near the business, and the buyer will typically work in the business after they have purchased it.

Buyers of main street businesses often have never owned a business before or been involved in the purchase or sale of a business before, and tend to have little or no knowledge of business transactions, financing, etc.

Merger & Acquisition (M&A) Advisors:

M&A Advisors typically represent owners of businesses valued in excess of $2 million. These businesses may be multi-unit retail establishments, dealers and franchisors, but are more often manufacturers, distributors or service businesses with regional, national or international clientele.

Businesses represented by M&A advisors may have a separation of ownership and management, and will almost always have some middle management personnel.

Businesses represented by M&A advisors will typically have much greater expansion potential than smaller businesses typically represented by business brokers.

Businesses represented by M&A advisors will have a much higher incidence of having their own proprietary brand, branded products and innovations.

Businesses offered by M&A advisors have a greater potential for garnering higher sale prices and earnings multiples, sometimes considerably higher.

Buyers of businesses represented by M&A advisors may be individuals (at least on the lower size deals), but are more often other companies and/or private equity groups.

Buyers of M&A advisor-represented businesses have typically owned and/or purchased and sold companies before. They also tend to be well-educated, well-connected and fairly experienced in business matters. As such, these buyers can be more of a "competitive threat" in that they can and may attempt to use their knowledge to their advantage (and your detriment). To that end, business sellers of mid-size companies should engage representation that has the education, experience and skill to match these shrewd buyers.

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Are You Better Off Keeping Your Business?