Acquisition Advisors | Earnings Multiples – EBITDA, Profit or Earnings?
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08 Oct 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 10th 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.

($000’s)

Income Statement
XYZ Company

Revenue …………………………………………..$10,000

Cost of Sales ……………………………………..($3,000)

Gross Profit …………………………………………$7,000

Operating Expenses* …………………………($5,000)

Operating Profit ………………………………….$2,000

Non-Operating Expense** …………………($1,000)

Pre-Tax Profit ……………………………………..$1,000

Tax ……………………………………………………($400)

After Tax Profit ……………………………………..$600

* Operating Expenses include $1,000,000 of salary to the owner, $400,000 in owner perquisites and $250,000 in depreciation.
** Non-Operating Expense is $500,000 in interest and a $500,000 legal bill to settle a dispute.

Miscellaneous Profit Calculations1
(From the above income statement)

Operating Profit ……………………………………$2,000

Pre-Tax Profit ……………………………………….$1,000

After-Tax Profit ……………………………………….$600

EBIT ……………………………………………………$1,500

Adjusted EBIT2 ……………………………………..$2,000

EBITDA………………………………………………..$1,750

Adjusted EBITDA2 ………………………………..$2,250

SDCF2 ………………………………………………..$3,650

1 For additional profit calculations, see each “profit” line on the accompanying XYZ income statement.
2 Non-recurring expenses added back.

Glossary of terms

Gross Profit – Revenue minus direct expenses (Direct expenses are often referred to as cost of goods sold.)

Operating Profit – Gross Profit minus Operating Expenses (Operating expenses are often referred to as sales, general and administrative expenses.)

Pre-Tax Profit – Operating Profit minus any non-operating expenses (except taxes).

After-Tax Profit – Profit after all expenses have been deducted including taxes.

Net Profit – See “After-Tax Profit.”

Profit – A general term for profitability.  Examples include gross profit and net profit.

Earnings – A term for profit. Generally considered to mean net profit or after-tax profit.

EBIT – Earnings Before Interest and Taxes.

EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization.

Seller’s Discretionary Cash Flow (SDCF) – EBITDA plus owner compensation plus all expenses that are non-recurring and any expense that is not necessary for the ongoing operation of the business.

Owner Earnings – See “SDCF” above.

Taxable Income – See “Pre-Tax Profit.”

Normalized Earnings – “Normalized” refers to the act of adding back to profit all excess owner compensation (salaries that are not “fair market”) and any expenses that are non-recurring or unnecessary for the ongoing operation of the business.

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