Valuing a Company? Don’t Stop at EBITDA
What EBITDA Doesn’t Tell You About an Acquisition Target
How to determine the value of a company is one of the most important questions for investors to explore — yet the answer is always elusive, or at the very least debatable.
Conventional wisdom around ways to value a company says that value tracks closely with one metric in particular: earnings before interest, taxes, depreciation, and amortization (EBITDA). Without diving too deep into the strengths and weaknesses of this particular metric, EBITDA provides a useful way of comparing the sizes of different companies.
Investors considering an acquisition target will need to look closely at EBITDA. However, EBITDA shouldn’t be the primary decision-making factor. Digging deep into a company and looking beyond EBITDA helps investors identify its true value and determine whether a deal is a good investment.
Where Hard Numbers Fall Short
It’s tempting to assume the best way to evaluate a company is with hard numbers like EBITDA and other quantitative metrics.
There are several problems with finding the value of a company through EBITDA, though. First, EBITDA tracks how a company has performed in the past, but it doesn’t indicate how the company will perform in the future. Perhaps more important, EBITDA is only a proxy for cash flow, not actual cash flow. Relying on EBITDA alone creates dangerous misconceptions about what a company is capable of.
Another problem is that companies are more than just their historical financial performance. Their past and future performance is a reflection of the management team at the top and how well they lead the staff below them. Management's attitude, aptitude, and vision are what really matters — and those aren’t always apparent in the numbers.
They’re apparent in other ways, though. For example, when our team visits a company, we note the condition of the bathrooms and break rooms. Why? Because dilapidated spaces suggest that the company doesn’t respect its workers or vice versa. Either way, it’s a red flag. The company might have a healthy EBITDA, but if it also has an undervalued and therefore dissatisfied workforce, earnings might not stay healthy for long.
Learning From Soft Metrics
Soft metrics help an investor to understand the culture and character of a company. Acquisitions are also partnerships, so it’s vital to predict how well an existing team will work with a new owner/operator. If the fit isn’t right, the acquisition isn’t either — it’s really that simple. The challenge is finding ways to define and quantify soft metrics, which don’t lend themselves to empirical analysis like EBITDA does. Here are some different evaluation techniques we use:
Apply the “airport test” — Before we form a business partnership with someone, we imagine a simple hypothetical: If I were stuck in the airport with this owner or manager, would the experience be enjoyable or agonizing? If the answer is the latter, a long-term partnership isn’t advisable.
Size up the management team — We strive to understand the people who might become our future partners. Their motivations, their conduct, their principles, and their priorities should all factor into the valuation process. Character matters because when the unexpected happens (as happens a lot recently), how the management team conducts itself can determine outcomes more than anything else.
Look for strategy — A company’s current strategy can either be parallel or perpendicular to what investors have planned. Alternately, lack of strategy suggests the company lacks vision — and may be lacking in other ways, too. Strategic alignment is important for a smoother acquisition and quick success thereafter.
Explore growth avenues — A large EBITDA might obscure the fact that earnings can’t realistically grow much higher due to the company reaching the ceiling of its potential. On the flip side, a lower EBITDA might obscure that the company has tremendous growth potential. Understanding whether a company is at the beginning, middle, or end of its growth is critical. Investors also need to know how much effort a growth strategy will take.
We never ignore EBITDA, but the value of a business is determined by myriad factors. Pinpointing the true value takes hard and soft metrics, combining objective analysis and gut intuition.
Rigorous evaluation has helped us avoid bad deals that looked ideal on the surface. It has also helped us find diamonds in the rough that other investors spurned. Of all the ways to value a company, our method is this: Look for owners we want to be partners with.
To learn more about our approach, get in touch today.