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YOU'RE KILLIN ME SMALLS!
EBITDA multiples are NOT the right way to buy a business. EBITDA is valuable and has it's place but you need to understand the nuances. This is going to be a LONG thread. I can't watch this confusion any longer. (1/25)
YOU'RE KILLIN ME SMALLS!
EBITDA multiples are NOT the right way to buy a business. EBITDA is valuable and has it's place but you need to understand the nuances. This is going to be a LONG thread. I can't watch this confusion any longer. (1/25)
2/25
Let's start at the top. Why do we use EBITDA - or any - multiples? They're a proxy for a discounted cash flow. It's a quick enough substitution that it is close enough to be sufficient. Usually. By skipping the DCF, you aren't factoring in the current or future growth (both
Let's start at the top. Why do we use EBITDA - or any - multiples? They're a proxy for a discounted cash flow. It's a quick enough substitution that it is close enough to be sufficient. Usually. By skipping the DCF, you aren't factoring in the current or future growth (both
3/25
are very important!) and the WACC (so you are are excluding capitalization (that's fine b/c you are excluding it in EBITDA too, more on that later) but also any measure of risk that would be captured in your discount rate - that risk matters!). But even then, I give you a
are very important!) and the WACC (so you are are excluding capitalization (that's fine b/c you are excluding it in EBITDA too, more on that later) but also any measure of risk that would be captured in your discount rate - that risk matters!). But even then, I give you a
4/25
pass and say you can SWAG it with a higher or lower multiple to compensate for growth, customer concentration, etc.
Now let's dissect EBITDA:
Earnings - yes, we care about this!
(Before)
Interest - we don't care how the seller is capitalized; we will use our own debt or
pass and say you can SWAG it with a higher or lower multiple to compensate for growth, customer concentration, etc.
Now let's dissect EBITDA:
Earnings - yes, we care about this!
(Before)
Interest - we don't care how the seller is capitalized; we will use our own debt or
5/25
no debt. Additionally, if we are using debt, and b/c interest is currently tax deductible, people use EBITDA as a proxy of ability to pay interest payments (and principle, but not tax-free) when they are buying with lots of leverage. Wouldn't recommend for SMB when it's a
no debt. Additionally, if we are using debt, and b/c interest is currently tax deductible, people use EBITDA as a proxy of ability to pay interest payments (and principle, but not tax-free) when they are buying with lots of leverage. Wouldn't recommend for SMB when it's a
6/25
significant portion of your net worth vs a PE firm who has many portfolio companies.
Taxes - again, tax payments will change based on your capitalization, tax law changes, corporate structure (are you an LLC, C-corp, etc.), and a handful of other factors. And if your
significant portion of your net worth vs a PE firm who has many portfolio companies.
Taxes - again, tax payments will change based on your capitalization, tax law changes, corporate structure (are you an LLC, C-corp, etc.), and a handful of other factors. And if your
7/25
earnings change, then your taxes change. No earnings, no taxes -> no running a loss due to taxes alone.
Depreciation - this is what triggered the thread. "Why do we care about depreciation, it's non-cash" they say. Uh, sure? Maybe it's non-cash this year? But you did buy
earnings change, then your taxes change. No earnings, no taxes -> no running a loss due to taxes alone.
Depreciation - this is what triggered the thread. "Why do we care about depreciation, it's non-cash" they say. Uh, sure? Maybe it's non-cash this year? But you did buy
8/25
the asset, right? I assume you paid cash or something similar to cash? I think people get this wrong because most know depreciation through the lens of buying real estate. Part of your depreciation for a building is, say, the roof. But with a long enough useful life, you may
the asset, right? I assume you paid cash or something similar to cash? I think people get this wrong because most know depreciation through the lens of buying real estate. Part of your depreciation for a building is, say, the roof. But with a long enough useful life, you may
9/25
not see the roof replaced. The depreciation seems like a free tax deduction (although you'll have a lower basis asset at sale; the tax man comes eventually (yes 1031...not worth the further discussion here)). With a long enough useful life and little req'd maintenance, I
not see the roof replaced. The depreciation seems like a free tax deduction (although you'll have a lower basis asset at sale; the tax man comes eventually (yes 1031...not worth the further discussion here)). With a long enough useful life and little req'd maintenance, I
10/25
understand why people miss this. Imagine instead: a transportation business. You own trucks and trailers and employee drivers. Your truck has a 7 year useful life and trailers have 10. If you are buying that business and just look at EBITDA, $2M/yr looks great. Oh - a 3x
understand why people miss this. Imagine instead: a transportation business. You own trucks and trailers and employee drivers. Your truck has a 7 year useful life and trailers have 10. If you are buying that business and just look at EBITDA, $2M/yr looks great. Oh - a 3x
11/25
multiple! Fantastic! But if you have 50 trucks that cost $140k each, that's roughly $20k/yr. Same with the 125 trailers -> $2k/yr. Yeah, you could skip spending on trucks and trailers this year if you need to. But "normalized" you need $1M/yr on trucks and $250k/yr. So you
multiple! Fantastic! But if you have 50 trucks that cost $140k each, that's roughly $20k/yr. Same with the 125 trailers -> $2k/yr. Yeah, you could skip spending on trucks and trailers this year if you need to. But "normalized" you need $1M/yr on trucks and $250k/yr. So you
12/25
really have a business that only kicks off $750k/yr of cash. Hmmm that 3x multiple is now 8x. And when happens if you skip the CapEx? You were going to replace the oldest trucks and trailers. We all know oldest cars take the most maintenance $. Same w/ trucks. Your maint
really have a business that only kicks off $750k/yr of cash. Hmmm that 3x multiple is now 8x. And when happens if you skip the CapEx? You were going to replace the oldest trucks and trailers. We all know oldest cars take the most maintenance $. Same w/ trucks. Your maint
13/25
costs shoot through the roof. No CapEx with the big hits to cash flow, but now your earnings are down. And if you always stay one year behind, you just compressed margins. Don't spend on unnecessary CapEx, but smart spending maxes long-term cash flows. (Another reminder
costs shoot through the roof. No CapEx with the big hits to cash flow, but now your earnings are down. And if you always stay one year behind, you just compressed margins. Don't spend on unnecessary CapEx, but smart spending maxes long-term cash flows. (Another reminder
14/25
that EBITDA multiples are a proxy for a DCF and CapEx strategy spending is captured in that DCF but not in our multiple). DEPRECIATION MATTERS!
Amortization - this is 50/50. If it's a customer list being amortized, sure, exclude it. If it's a patent, well obviously that
that EBITDA multiples are a proxy for a DCF and CapEx strategy spending is captured in that DCF but not in our multiple). DEPRECIATION MATTERS!
Amortization - this is 50/50. If it's a customer list being amortized, sure, exclude it. If it's a patent, well obviously that
15/25
is critical to the business (and likely req's R&D in the same way trucks req CapEx). Discretion is important.
So EBITDA is a fine starting place. But where do we go? We move towards free cash flow (FCF). From EBITDA, calculate a normalized CapEx and amortization amount.
is critical to the business (and likely req's R&D in the same way trucks req CapEx). Discretion is important.
So EBITDA is a fine starting place. But where do we go? We move towards free cash flow (FCF). From EBITDA, calculate a normalized CapEx and amortization amount.
16/25
This becomes particularly apparent when evaluating, e.g., and asset-based trucking co that owns it's trucks and employs drivers vs asset-light that hires independent contractors (ICs) who own the truck themselves. Using EBITDA multiples, you pay much more for asset-light.
This becomes particularly apparent when evaluating, e.g., and asset-based trucking co that owns it's trucks and employs drivers vs asset-light that hires independent contractors (ICs) who own the truck themselves. Using EBITDA multiples, you pay much more for asset-light.
17/25
And it makes sense. You need to pay ICs a lot more than an EE per mile because they have to pay off their truck. They have a large hurdle to clear before $ fall to their pocket. EEs have no hurdle but a lower variable cost. So two companies of same size -> asset light will
And it makes sense. You need to pay ICs a lot more than an EE per mile because they have to pay off their truck. They have a large hurdle to clear before $ fall to their pocket. EEs have no hurdle but a lower variable cost. So two companies of same size -> asset light will
18/25
have much lower margins. But no CapEx. EBITDA multiples miss this. If we start with EBITDA and normalize for CapEx, then we capture it properly.
Are we done yet? Maybe. I wouldn't fault you for stopping there. But we should discuss growth. With EBITDA - norm'd CapEx, you
have much lower margins. But no CapEx. EBITDA multiples miss this. If we start with EBITDA and normalize for CapEx, then we capture it properly.
Are we done yet? Maybe. I wouldn't fault you for stopping there. But we should discuss growth. With EBITDA - norm'd CapEx, you
19/25
don't need to worry about growth CapEx. And you probably don't need to worry about (net) working capital (NWC) because you're flat. But you are presumably buying a business to grow, right? Maybe not. But I am.
A cautionary tale: let's assume you have a biz w/ employees
don't need to worry about growth CapEx. And you probably don't need to worry about (net) working capital (NWC) because you're flat. But you are presumably buying a business to grow, right? Maybe not. But I am.
A cautionary tale: let's assume you have a biz w/ employees
20/25
(EEs) and you collect your revenue from health insurance companies who pay 90 days in arrears (reasonable for large cos that manage NWC and you, the small co, can't do much about it). You likely pay your EEs 2x/mo. Let's assume your revenue is $1M and your EBITDA (ah!) is
(EEs) and you collect your revenue from health insurance companies who pay 90 days in arrears (reasonable for large cos that manage NWC and you, the small co, can't do much about it). You likely pay your EEs 2x/mo. Let's assume your revenue is $1M and your EBITDA (ah!) is
21/25
$200k. A healthy 20% margin. No D&A. No debt for now. So you just worry about taxes. Let's assume you pay your people $600k and have 8 EEs -> $75k/EE. If you have the opportunity to grow 20% really quickly (practicalities aside), you would pay $30k for 3 months of EE work
$200k. A healthy 20% margin. No D&A. No debt for now. So you just worry about taxes. Let's assume you pay your people $600k and have 8 EEs -> $75k/EE. If you have the opportunity to grow 20% really quickly (practicalities aside), you would pay $30k for 3 months of EE work
22/25
before you collect a dime of AR. And how long before the extra cash flow from that 20% increase breaks even? 7.5 months! That's fine, of course, but do you have $30k extra lying around for the NWC hit? What if you're looking at a biz that's growing faster? Again, EBITDA
before you collect a dime of AR. And how long before the extra cash flow from that 20% increase breaks even? 7.5 months! That's fine, of course, but do you have $30k extra lying around for the NWC hit? What if you're looking at a biz that's growing faster? Again, EBITDA
23/25
multiples don't capture growth. But they also don't capture NWC funding needs.
In summary. EBITDA multiples are a proxy for DCFs. Good enough? Sure, if you normalize for CapEx. You won't get me to agree that you can NOT normalize for CapEx unless every biz you compare has
multiples don't capture growth. But they also don't capture NWC funding needs.
In summary. EBITDA multiples are a proxy for DCFs. Good enough? Sure, if you normalize for CapEx. You won't get me to agree that you can NOT normalize for CapEx unless every biz you compare has
24/25
the same CapEx req's. Ironically, I'm in a ~$0 CapEx biz (computers are it for us) but there are very few in the SMB space. Instead? EBITDA minus normalized CapEx. Every time.
Do you need to factor NWC needs or growth CapEx? No. But don't forget what you're omitting.
the same CapEx req's. Ironically, I'm in a ~$0 CapEx biz (computers are it for us) but there are very few in the SMB space. Instead? EBITDA minus normalized CapEx. Every time.
Do you need to factor NWC needs or growth CapEx? No. But don't forget what you're omitting.
25/25
Go in with eyes open because the growth isn't free!
EBITDA is valuable. It has it's place. But it is missing some key items.
Phew.
Yes, I will post this thread in response every time I see people shrugging off depreciation now.
Go in with eyes open because the growth isn't free!
EBITDA is valuable. It has it's place. But it is missing some key items.
Phew.
Yes, I will post this thread in response every time I see people shrugging off depreciation now.
