If you take a look at public company valuations you will surely run across the multiples based on the EBITDA, EBIT and net income. But why don’t private company appraisal use these as often?
The short answer: you have better choices of earnings basis to run your business valuation. Why? Because privately owned companies do not comply with accounting standards like GAAP in their financial records.
Now, if you take a look at the public companies, the situation changes. These companies sell their stock to the general public. So they must comply with stringent financial reporting requirements. And this includes GAAP compliance and financial records auditing by independent accountants.
In contrast, privately owned businesses rarely sell their stock to outsiders. The one requirement such companies do face is to file their tax returns. So the owners engage smart CPAs for this. Unfortunately, the starting point for these returns is often the proverbial shoe box full of receipts.
Moreover, private company owners focus on minimizing taxable income. So they and their accountant often resort to creative financial records. As a result, you never know how much you can trust the accounting figures such as EBITDA, EBIT or net income.
How business owners skew their accounting profit numbers
For example, take the EBITDA number. It stands for business earnings before the interest expense, taxes, depreciation and amortization. Now, business owners may be getting loans on so-called sweetheart terms. In other words, the interest charged by a friendly party may differ quite a bit from the market rates available from commercial lenders.
Also, private companies usually do not pay taxes directly. Instead, business owners get to pay personal taxes on the pass through income from their companies. Again, their razor sharp CPAs come to the rescue and work really hard to reduce those taxes.
Similarly, private companies tend to accelerate their cost recovery through early depreciation of business assets. For example, the Internal Revenue Code Section 179 allows business owners in the US to expense certain assets. So the company can get the tax deduction from an asset purchase that otherwise would require years of depreciation.
Watch out for deferred maintenance and asset replacement
As a result, you should tread carefully when determining how a given business uses and replaces their assets. This could make a big difference in business earnings as the owners put the company up for sale. But the unwary business buyer may miss the need for a critical asset replacement. And be saddled with a sizeable expense down the road.
Financial statement normalization or adjustment
Business appraisers know this all too well. To work around the challenge they subject the company’s financial records to so-called normalization.
Why? Because the appraisers want to estimate the company’s actual earning power. So they carefully review and adjust the financial records to flush out the earnings they can work with.
What earnings do these pros use? If you guessed some form of cash flow, you are on the right track. In fact, most appraisers prefer two types of cash flow measures:
Cash flow for apples to apples comparison
If you know the NCF or SDE cash flow for a given company, you can do pretty accurate market comparisons against other businesses. And this lies at the heart of the market approach to business valuation.
In other words, you compare your subject company to its industry peers based on the cash flow generating capacity. No matter what the companies report on their tax returns, their cash flow numbers reflect their actual financial performance.
Key takeaway: EBITDA, EBIT and net income multiples may be misleading
So there you have it. Instead of relying on questionable accounting profitability measures, do yourself a favor. Focus on the company’s real earning power when trying to figure out its value. Use cash flow in your business valuation.