When working out the value of a business there are two critical quantities (the P's and Q's of valuation):
Price - the cost of capital or the risk of the business (or earnings multiple).
Quantity - the proxy for future free cash flow (typically an adjusted EBITDA).
Free cash flow is the cash left over from profit after taking into account one off and non-operational expenses (and revenue), increases in working capital and investments required to maintain the cash flows expected.
When assessing the value of a business we want to capitalise the future earnings based on what is directly related to the business - free from the impacts of sale of assets, unexpected redundancy payments, one off legal costs and other things. We wish to normalise the cash flows to represent what firm investors expect in the future. Normalisation is setting earnings at a level that is to be expected on an ongoing basis. It should be adjusted for market level costs and one off items.
The process of EBITDA normalisation is a way of smoothing out the free cash flow only expected from just the business and not all the "work arounds" the accountants and tax lawyers can achieve to increase your net profits.
This gives us what is called firm valuation - the value of the enterprise for all stakeholders (equity holders and debt holders).
The typical adjustments that we use to determine ongoing EBITDA include:
Wages (and superannuation) to owners at a market level.
Rent of offices or factory at a market level.
Lump sum or regular super payments over Superannuation Guarantee Charge.
Personal expenses such as mobile phone and car costs, costs of refitting the owners beach house or family home (yes this happens).
Legal costs in defending claims such large debtors, employee claims, partner disputes.
One off marketing programs. A large marketing program may generate a platform for growth but it is not appropriate to charge this to a single year. It should be spread over 2-3 years depending on extent.
One off or abnormally high costs of debt recovery.
One off accounting costs associated with restructuring.
Investment in new software that is normally expensed in a single year should be spread out over several years.
Drops in revenue from long term illness or absence of the owner are unlikely to be repeated in the future, and should be either removed or smoothed out.
Consideration should also be given to short term changes in the business model that are likely to impact cash flow. These include:
Price changes (hopefully increases).
Immediate increases in employees or wages.
Changes in gross profit margin.
Changes to lease costs.
Reliance on the owner should be reflected in a lower multiple not reduced earnings.
Another typical, but often contentious, adjustment is future growth in revenue. Growth should be considered in ongoing EBITDA based on circumstances such as:
Demonstrated history of revenue increases that match the strategy of the business.
Price increases that match market and industry expectations.
Implementation of strategy that is inline with past experience.
Market value dictates that the value be considered with all information available and no anxiousness on the part of buyer and vendor. This can be interpreted as meaning that excessive revenue increases that are beyond the expectations of one party and cannot be validated through reasonable strategic actions or past results should be excluded from the market valuation process.
It may contribute to strategic value but that is another BLOG topic altogether. Our latest Whitepaper (Valuation 101 - What You Should Know About Valuation) explains the theory of valuation, why you need a valuation and the process of doing a valuation. Download a copy and feel free to contact us for an obligation-free confidential discus
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