The EBITDA Multiple Problem

By Maurie Cashman

An EBITDA multiple is often relied upon by business owners trying to understand the value of their business. This is often reinforced by business brokers who like to rely on “rule of thumb” multiples to value a business for listing. I have run into more than one occasion when an owner of a business with over $20 million in sales came to me after talking to a broker who put a matrix in front of them and asked them to choose a listing price based on a multiple of EBITDA or some other factor. You worked hard to build your business. Why would you make one of the most important business you will ever make based on an arbitrary measurement that may not reflect the value of your business at all?

Comparison of Two Companies

Acme Pool Supply sells parts and equipment for the swimming pool industry. So does Ace Pool Supply. Acme has EBITDA of $500,000 as does Ace and each want to sell their business. Acme’s owner Wiley was talking to his uncle from Arkansas who told him he should be able to get 5 times EBITDA for his business based on what he was told business’s sell for. So Wiley listed his business with a broker for $2.5 million.

Acme sells primarily to retailers, who sell the t end customers. Acme turns its inventory 2.5 times per year. It does not have a web-site that can support online sales and does not have an inventory management system in place. Acme operates out of an old facility and has not updated the building or equipment in 20 years. Acme’s sales have declined at a 2% rate over the last five years. It is operating the business as a cash cow, taking as much cash as possible out of the business to support the owner’s lifestyle. Acme has no outside sales force and relies on a printed catalogue to advertise to and inform its customers. Company management has been in place for twenty years.

Ace also sells to retailers but it also sells to customers direct via a website it installed two years ago. It installed a state-of-the-art inventory management system at the same time and is turning its inventory 6 times per year. It operates out of a newer facility that is 50% smaller than that of Acme but at about the same cost since it needs less space to house its inventory. The business has been growing at a 5% rate over the last five years, even though the housing industry has been depressed. It expects an upturn in the housing industry and has positioned itself for significant growth in the next five years. It has a strong management team with compensation tied to growth.

Let’s compare the two businesses on an EBITDA Multiplier basis: (this is greatly simplified)

Acme would be valued at $270,000 more than Ace based on a simple EBITDA multiple rule of thumb. After deducting the additional investments that need to be made to the business however, we arrive at a much different result: Ace is worth $480,000 more! And this does not take into account that the difference in growth rates between the two is seven points! I’ll leave it to you, which company would you rather own?

Not convinced?

Take a look at what Warren Buffet had to say in his annual letter to shareholders on the subject:

“…GAAP-prescribed depreciation charges, … are necessarily based on historical cost. Yet in certain cases, those charges materially understate true economic costs. Countless words were written about this phenomenon in the 1970s and early 1980s, when inflation was rampant. As inflation subsided – thanks to heroic actions by Paul Volcker – the inadequacy of depreciation charges became less of an issue. But the problem still prevails, big time, in the railroad industry, where current costs for many depreciable items far outstrip historical costs. The inevitable result is that reported earnings throughout the railroad industry are considerably higher than true economic earnings.”

“At BNSF, to get down to particulars, our GAAP depreciation charge last year was $2.1 billion. But were we to spend that sum and no more annually, our railroad would soon deteriorate and become less competitive. The reality is that – simply to hold our own – we need to spend far more than the cost we show for depreciation. Moreover, a wide disparity will prevail for decades.”

Think of the money you could be leaving on the table by relying on a simplistic rule of thumb. It is well worth taking a little time and spending a bit to have a qualified valuation of your most important asset completed.

© 2017 Aspen Grove Investments, Inc.