Earnings Multiples - Making Sense of EBITDA - Profit and 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 2007 income statement for XYZ Company that accompanies this article. How much profit did XYZ make in 2007? 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 tenth 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 that 2007 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, so 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.

Article Source: http://www.searchforum.org/articles

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