EBITDA and Multiples: The Perception of Risk


ebitdaIn the world of mergers and acquisitions, it’s common to hear business owners and their advisors reference a transaction price or investment based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization).

While multiples of EBITDA can sometimes provide a good reference point, there are a number of reasons why only basing a business price or share in an investment can be quite dangerous.


What’s The “Enterprise Value”?

When using multiples of EBITDA, what we are attempting to create is the “Enterprise Value”. Most business owners want to focus on the enterprise value, and if the enterprise value falls short of expectations, they often ask us how it can be increased. In relatively short order.

Keep in mind there are two parts to the equation: EBITDA and the Multiple. So let’s look at which is easier to improve. EBITDA or the Multiple.

It’s important to keep in mind that the Multiple is really the inverse of the risk perceived by potential buyers or investors related to your business.

As risk goes down, the Multiple goes up. And that increases the price. Perceived risk is related to the business continuing to produce the net income or cash flows that it does currently.

Or, even better, the perception that net income and cash flows will improve over time. It is this perception that a business owner/seller has to keep in mind. It’s important to put yourself in the shoes of the prospective buyer and how they will view your business.


Several Key Factors …

There are a number of key factors related to EBITDA and the Multiple that impact how a purchaser or investor looks at a business. Let’s look at several:

1.) What’s the Time Period for EBITDA? If a company’s performance has varied in recent years, the time period for which EBITDA is calculated could significantly influence the implied multiple.

Consider a company that produced EBITDA of $100 last year, has an EBITDA run-rate of -$70 this year, and is expected to produce EBITDA of $130 next year. A reasonable multiple, in the perception of the buyer, would suggest values ranging from negative to significantly positive. So what EBITDA should you use? The proper EBITDA would be a current “normalized” level of EBITDA.

2.) Normalization Adjustments in EBITDA:Sometimes a company’s reported EBITDA may not reflect its true operating performance. It is often appropriate to “normalize” EBITDA due to unusual, non-recurring, or discretionary income or expense items that a potential buyer would not be likely to incur. These normalization adjustments can have a material impact on an implied multiple of EBITDA.

3.) CAPEX: Depreciation and Working Capital: While EBITDA often serves as a proxy for net cash flow, it is important to remember that EBITDA is not equal to net cash flow.

Capital expenditures (“CAPEX”) reduce a company’s net cash flow, but are not factored into an EBITDA calculation since CAPEX does not hit the P&L. Also, as companies grow, they typically require investments in higher levels in accounts receivable, inventory and other working capital assets to support higher revenue levels. These investments are a use of future cash, but are not reflected in EBITDA.

4.) Risk: The largest factor driving a multiple of EBITDA is risk. Risk, in an investment context, describes the likelihood that expected cash flows will be received. The higher the risk, the lower the likelihood that cash flows will be received as predicted.

The lower the risk, the higher the likelihood that actual future cash flows will equal expected future cash flows. Investment theory dictates that investors require a higher reward for higher risk, and require a lower reward for lower risk.

Therefore, the level of risk drives the percent of annual return (or reward) that the investor requires. A simple example is that if you invest money into a risk free savings, you may earn 1% per year of interest in today’s interest rate environment. Whereas if you invest money into a venture capital fund, you expect an annual return of 30-50% because of the high risk nature of the investment.


The “Discount Rate” …

The expected total rate of return is also called a “discount rate” that can be used to calculate the today’s value of all cash flows that will be received in the future (present value). A valuation multiple is short hand way of expressing a required rate of return or a discount rate.

A multiple is equal to the mathematical inverse of the discount rate, minus growth. Risk has an inverse correlation to a value multiple. The higher the risk, the lower the value multiple, because an investor is willing to pay less for the investment in order to ensure a higher ultimate return. The lower the risk, the higher the value multiple, because the investor is willing to take a lower return.

5.) Growth: Another key driver of multiples of EBITDA is growth. A purchaser or investor asks the question: How much is this cash flow going to grow year after year into the future. Growth has a direct correlation to the multiple. The higher the projected growth, the higher the price an investor is willing to pay.

A business seller, depending on their time-frame, should focus on taking specific action to address the issues that reduce risk and the buyers/investors perception of risk and on increasing growth through improvement in EBTIDA profit. And an experienced professional can help in making those improvements.

Revitalization Partners is a Northwest business advisory and restructuring management firm with a demonstrated track record of achieving the best possible outcomes for our clients. We specialize in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations.
Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Corporate Debt at Risk in Current Economy


debtAmerica has a debt problem, but it isn’t what you think.

Yes, the federal debt is growing and many Americans are still struggling to pay off mortgage and student loans. But the larger problem is only discussed in financial circles.

Like consumers, the richest one percent of companies have enough cash to pay off their debt.

But for the rest, corporate cash only represents fifteen percent of what they owe; a ten-year corporate low.

But wait: The cost of corporate debt is at an all-time low and big US companies have been very conservative with their finances.

They’ve collectively hoarded hundreds of billions of dollars in cash, instead of spending it on wage increases, hiring or expanding their operations.


The Reality Is Much Different …

The reality is much different and more concerning. Much of the cash is held by just a few companies, while is debt is ballooning at other, weaker companies, while investors, desperate for larger returns, rush in to lend to them. If interest rates rise and/or the economy falters, these investors could face losses, perhaps steep along with the changes.

The broader economy is affected as companies with more debt have to cut back further and lay off more when a downturn hits.

“There is a misconception that companies are swimming in cash” says Andrew Chang, a director at S&P Global Ratings. “Actually, they’re downing in debt.”


Just 25 Companies Own 50% …

It turns out, just like people, companies have a wealth gap. Of the $1.8 trillion in cash siting in US corporate accounts, half belongs to just 25 of the 2000 companies tracked by S&P Global Ratings.

Outside of Apple, Microsoft, Google and the rest of the corporate one percent, cash has been falling over the last two years as debt has been rising. It now covers $15 of every $100 they owe. Less than during the financial crisis of 2008.

The number of companies that have defaulted on debt this year has already passed all of 2015, which was itself the most since the financial crisis. Of public companies that appear to be quality debtors, many are so stretched they are only a quarter or so of being rated “junk.”


Debt Rated “JUNK” in Bad Shape …

Companies whose debt is already rated “junk” are in the worst shape.

To pay back all that they owe, they would have to set aside every dollar of operating earnings for the next 8.5 years.

Longer than in the height of the financial crisis.

You shouldn’t borrow what you can’t pay back; that’s how we got into this economic mess in the first place.

But figuring out how much debt you can take on or what a reasonable lender will lend is a bit tricky.

There are several metrics that will help keep you honest about how much debt you can take on.


How Much Debt Is OK?

1. Projected Operating Income / Interest expense. Called the interest-coverage ratio, it tells lenders whether or not you can cover your interest payments. (They may have a little leeway on principal, at least in the early periods.) If you can’t pay interest, the bank regulators can ask the bank to increase their reserves or write off the loan. Both are bad.

“Operating income” is revenue less all expenses except interest and taxes. If you could perfectly predict the future, an acceptable ratio would be 1.0. But lenders are skeptical and want some cushion. Assume the ratio should be more like 1.2 to 1.5.


2. Projected Net income + Depreciation / Principal payment. Maybe you can keep the game going by covering your interest payments, but not have a prayer of paying back the principal.

This ratio will smoke you out. It uses in the numerator the free cash available to the enterprise, after all expenses. Like the interest-coverage ratio, target 1.2 to 1.5.

If this ratio is less than 1.0 in the early months, banks may be willing to adjust your principal payment schedule, so long as the other aspects of your company look sound. Need capital to fund growth? Tough luck: Pull it out of equity.


3. Projected EBITDA + Lease payments / Interest + Lease payments + Principal / 1-tax rate. While it looks scary, this ratio is meant to provide comfort. It combines the above two ratios, but gives lessors (landlords and equipment-rental firms) an extra level of clarity and safety by explicitly highlighting the impact of all lease payments. (In the first two ratios, lease payments are pulled out of the numerators.)

In this ratio, EBITDA stands for “earnings before interest, taxes, depreciation and amortization”-the basic operating income of the company before non-cash expenses. Principal is adjusted to a pre-tax basis. New companies should shoot for a ratio of 1.25; established ones, 1.1.


A Concerned Market Will …

If the market gets concerned, it will start demanding significantly higher interest rates.

Of course, lenders can get things horribly wrong. They didn’t catch the last debt bubble pouring money into bonds and mortgages despite signs that homeowners couldn’t afford them.

And like the last crisis, the problem may not end there. Many companies have “rolled over” their old ones, taking on new loans with more debt.

And as long as interest rates are very low, that may work. But when things start to fall apart due to a weak economy and/or higher interest rates, things fall apart very quickly.

imagesRevitalization Partners is a Northwest business advisory and restructuring management firm with a demonstrated track record of achieving the best possible outcomes for our clients. We specialize in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations.

Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Advent’s smartcard firm Oberthur set for Paris share listing, say sources: Reuters

(Reuters) Advent International is looking to press ahead with an initial public share offering (IPO) for its French smartcard maker Oberthur Technologies, having rebuffed a joint bid made by two other private equity firms, Carlyle and Eurazeo, sources familiar with the matter said. Oberthur Technologies, which ranks as the world’s second largest manufacturer of smartcards behind Gemalto, is slated to go public in Paris by the end of the year, the sources said. The application for a listing on Euronext is expected to be made in the next two weeks, another source said. A consortium of Carlyle and Eurazeo was vying with an alliance of PAI and Silver Lake to buy Oberthur. But PAI and Silver Lake walked away without making an offer, while Carlyle and Eurazeo’s bid failed to meet Advent’s expectations of 1.7 billion euros, two of the sources said. Spokesmen at Advent, Oberthur and Eurazeo declined to comment. Carlyle and PAI were not immediately available for comment. Advent, which is being advised by Rothschild, expects to get a better price with a stock market listing and has appointed banks to work on the share offering, they said. JPMorgan, Morgan Stanley and Deutsche Bank have been brought in as global coordinators while Societe Generale, Natixis, HSBC and BNP Paribas are acting as bookrunners on the deal, two of the sources said. Advent, which is also in the process of listing its British payments processing firm Worldpay in London, started reviewing strategic options for Oberthur earlier this year. Headquartered in Hauts-de-Seine, on the outskirts of Paris, Oberthur reported earnings before interest, taxes, depreciation, and amortisation (EBITDA) of 147 million euros in 2014, up from 132 million euros the previous year. It expects EBITDA to increase to around 175 million euros in 2015, a banker familiar with the company said. Oberthur’s main rival Gemalto’s shares trade at a multiple of enterprise value to forecast EBITDA of 8.8, while Ingenico Group and Wirecard AG trade on multiples of 12.3 and 16.1 respectively, according to Thomson Reuters data. Gemalto’s shares sank in September after the French firm announced the closure of its U.S. mobile payments service Softcard. Oberthur develops security software embedded in cards and other devices for making payments and giving access to transport networks or buildings. Advent bought 90 percent of Oberthur in 2011 for 1.15 billion euros while the company’s founder Jean-Pierre Savare and his family retained a 10 percent stake.

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Advent’s smartcard firm Oberthur set for Paris share listing, say sources: Reuters