M&A: Which earnings metric serves best?

The valuation of companies often revolves around the consideration of earnings multiples, a common practice in financial analysis. However, a crucial question arises: which earnings metric serves as the basis for these multiples? Are they referring to net income, earnings before interest and taxes (EBIT), or earnings before interest, taxes, depreciation, and amortization (EBITDA)? In the realm of small to middle-market enterprises, typically with revenues ranging from €10m to €50m, multiples are commonly applied to EBIT or EBITDA.

Interestingly, despite the prevalent focus on earnings, the most pivotal metric annually might be the net cash flow, which differs from the aforementioned earnings metrics. Net cash flow is determined by deducting capital expenditures from gross cash flow (EBITDA). When future capital expenditures are projected to be minimal, EBITDA closely approximates net cash flow. Conversely, when future capital expenditures are anticipated to align with depreciation, EBIT serves as a reliable proxy for net cash flow.

A significant aspect to consider in the EBIT versus EBITDA debate is that both pricing methodologies assume a debt-free transaction, wherein the seller is responsible for addressing any interest-bearing debt, either through adjusting the purchase price or settling the debt entirely at closing. Despite this, most mergers and acquisitions (M&A) professionals tend to utilize EBIT in pricing companies. The rationale behind this preference lies in the long-term expectation that capital expenditures in a growing company should at least match or exceed depreciation, rendering EBIT a more precise gauge of net cash flow compared to EBITDA. Nevertheless, certain industries still lean towards EBITDA for valuation purposes.

EBITDA multiples are favored in industries characterized by high capital intensity, where depreciation plays a significant role. These multiples account for the impact of varying depreciation rates. However, it's essential to note that the choice between applying multiples to EBIT or EBITDA can significantly affect the resulting valuation.

In small to middle-market transactions, investment bankers often reference EBIT and EBITDA, although what they truly mean is adjusted EBIT and adjusted EBITDA. This adjustment involves accounting for extraordinary, nonrecurring, and discretionary items in net income. Despite potential debates over what constitutes such items, sellers typically aim to include as many significant expenses and unusual losses as justifiable.

Several factors influence the determination of an appropriate EBIT multiple, including company size, profitability, management depth, sales diversification, current capitalization, industry, and prevailing market trends. While small to middle-market companies generally trade at multiples ranging from 5 to 7 times EBIT, exceptions abound, underscoring the importance of seasoned M&A professionals' judgment in arriving at an appropriate multiple.

Owners of less profitable businesses may find it challenging to accept that their operating assets are valued at only 5-7 times EBIT. Comparisons to price-to-earnings multiples (P/Es) of publicly traded stocks can be misleading, as P/Es are calculated based on after-tax net income, rather than pre-tax earnings. Additionally, factors such as corporate tax rates and interest expenses can significantly influence the translation of EBIT multiples into P/Es.

Ultimately, the valuation of a business involves more than just earnings multiples. Other considerations, such as nonoperating assets, working capital adequacy, and interest-bearing debt, must also be factored in to arrive at the company's true worth. While this discussion may lead one to consider estimating their business's selling price using the EBIT approach, it's advised to exercise caution.

Determining acceptable normalization adjustments, selecting appropriate multiples based on specific risks, and accounting for nonoperating assets require considerable expertise and experience. Hence, it's recommended to engage the services of an investment banker or a similarly qualified professional when pricing businesses, although opting not to do so should involve consulting someone knowledgeable in this field.