Valuing M&A Transactions - DCF & EV Multiples (M&A#2)

0:00 all right welcome to video number two of guide to m a transaction so in this video we're going to be discussing how do you actually value an m a transaction when you're buying a company how do you know how much to pay it's a difficult question really um you know if you're buying a listed company the price is fairly straightforward because it's based off usually uh the trading price of the company so it's a very liquid

0:28 you told the price the company at any minute of any given day of what the market's willing to pay but it gets a little bit trickier with private transactions so we're going to talk about two ways of valuing a company now i guess there's this there's a couple of points here number one is differentiating between what is value and what is price so price is what you pay for the company but value is what it's worth and

0:57 sometimes the market can distort one of the others for example during the 2000 stock bubble the price of companies became much higher than the value of companies and over time that corrected now you know throughout history there are periods where companies are overvalued undervalued which essentially means the price being asked or quoted in a liquid public market is higher than the value that you receive for a company so when you you're when you're structuring a transaction

1:27 you want to have an a value of the business internally so you know what it's worth fair value and then you want to negotiate the price and typically that price comes in around the value of the company typically there's not a huge amount of difference but on occasion you will be able to find a good value deal so how do we value business so there's two ways of valuing a business and what this essentially calculates is

1:54 when we say value of a business we talk about first and foremost the enterprise value of a business or equity value of a business and we'll talk about what the difference between those are a little bit later but for now let's talk about in broad terms so what is the value of a business so there's two ways of valuing a business number one is based on a discount of future cash flows so what this is is

2:20 essentially it's all of the future cash flows of a particular business essentially into perpetuity and a dollar today is worth more than a dollar tomorrow so essentially what we do is we discount all of those future cash flows so what that means is you know as you start going five years into the future ten years in the future the value of those cash flows start to get lower and lower and lower because they're further away and you

2:44 have things like inflation interest and and uncertainty and risk etc so how do we do this so we essentially build a model we build a dcf model is what it's called discounted cash flow model and what that is is we essentially model out the p l of the business so we go from revenue all the way down to ebitda so ebitda is a proxy for earnings of the company but it's different to net profit of a company so net profit is a very

3:14 inclusive term it includes lots of things that aren't included in ebitda for example depreciation interest but we'll talk about that a little bit later but ebitda is the universal proxy for the earnings of a business essentially we model out the the profit and loss of the company all the way down to ebitda for maybe three historical years sometimes more sometimes less but we need a bit of a run rate of historical because that then

3:46 forms the basis of our future forecasts this is our modeling assumption so and this is where there's a lot of judgment involved and a lot of risk to actually value it the wrong way because you could have an inherent bias and say okay we're expecting 10 a year revenue growth and model it out and value the business obviously the value is going to be higher than if the revenue growth came in lower than that so we just need to keep that in mind um

4:14 and a good way to kind of reference check our assumptions is to talk to management talk to the you know various stakeholders in the business and also compare it against different other ways of valuing the business because you've got a very large discrepancy between different ways of valuing the business then maybe you've gotten one of them wrong and the one you've gotten wrong is probably the dcf the discounted cash flow simply because the the level of professional judgment

4:38 required to calculate that and then we get to the ev or our headline price so we essentially model out all of our future cash flows in the future discount it back and the present value of those cash flows is our enterprise value now that's one way of valuing a business however the more common way that companies model a business is typically with the second method and this is the price earnings or pe multiple now we've used price earnings here but

5:10 it could be a mult it could be various different multiples and we'll go through what some of those multiples are a little bit later so for example ebitda multiple ebitda multiple net profit multiple or even revenue multiple depending on the type of industry and the maturity of the business will depend on what kind of multiple we'll use for valuing the business for example tech companies with no profits because they're scaling rapidly typically use a multiple of revenue

5:38 however the default multiple to use for any given company without necessarily knowing what its size is what industry it's in the majority of companies and people valuing companies use the ebitda multiple so how do we calculate that well first of all we need underlying ebitda and what that is is it's not necessarily ebitda for the last 12 months although it could be it could be an ebitda average over the last few years it could be an

6:08 average last six months actual ebitda plus forecast ebitda but the crux of this principle is we want to identify what sustainable ebitda is so typically the way we do that is we look at the last 12 months of ebitda and then we normalize it and the reason we normalize it is we take out non-recurring items for example potential cost synergies we need to look at the ebitda and figure out what it would be for us if we were to buy the

6:34 company and operate it for the next 12 months what would that ebitda be so again there's another kind of risk here similar to how we had with modeling assumptions in that and particularly with if you're buying a business off a broker or an investment bank their incentive because their their fee is based on a percentage of enterprise value they're trying to drive up the price as high as possible the risk here is that they've made ebitda

6:58 seem a lot higher what sustainable ebitda to be a lot higher than it actually ends up being so we need to be really careful really do our due diligence here and understand what we think underlying and sustainable ebitda is there's a lot of businesses that have been purchased on high ebitdas and those synergies or cost savings or non-recurring items haven't eventuated and it's actually blown out the multiple and the ev that they would have paid so the next component of the factor is

7:28 the multiple right so it says pe multiple here but the as we're using ebitda the correct terminology is actually e v multiple earnings um or ebitda over ev so rise over enterprise enterprise value multiple right but it depends on kind of what metric we're using as i said before it could be sales for the first part and then multiple of sales to get to your ev but typically the standard approach is to take underlying sustainable ebitda

7:56 times your ev ebitda multiple sorry ebitda either ev multiple equals your ev because your headline price so if you're doing a large deal typically you'll do both methods just to kind of sense check both of them but the basis you will for you use for your primary valuation will typically be the second one so your earnings multiple so as you can see down here the underlying ebitda of the business is key to both methods why is that so important

8:23 well for the first one because it forms the basis of our assumptions going forward if our ebitda is too high we're going to overvalue the business in in the dcf similarly with the second one if our ebitda is too high if there's too many kind of unrealistic normalizations or perhaps we've taken out non-recurring items which aren't actually non-recurring the risk is will over inflate ev so we need to be very careful about selecting the right ev

8:47 okay so how do we calculate the rest of the purchase price so all we've talked about so far is ev your headline price that's the terminology but how do we actually calculate the end dollar amount the final dollar amount that we actually pay so in almost all transactions it follows a very similar structure in that we start off with headline price and we do our price adjustments in any other matters and that gets us to our net purchase

9:12 price which is the ultimate amount of money that we end up paying so let's talk about each of these kind of three categories headline price adjustments are the matters one by one so the first one is headline price that's fairly straightforward so typically either done in one of the two methods we we talked about earlier which is earnings multiple dcf usually the earnings multiple that gets you to your headline price so let's let's take an example let's say ebitda

9:35 for a business we're looking at 10 million and the comparable multiple we're using we'll talk about how we actually get that multiple a little bit later is 10 times ebitda that means our enterprise value or headline purchase price is going to be 10 million times 10 equals 100 million dollars so the first number we're starting off with is 100 million dollars and we'll of course check that with a dcf analysis which we'll cover later in the course how do

10:02 you actually you know do modeling et cetera so we've got 100 million headline price is that the final amount we pay no because typically what we'll do is we'll go through and adjust for in the completion mechanism net debt and cash and potentially any working capital adjustment or capex now why do we adjust for these things so first of all net debt cash so a really important rule in m a and acquisitions is that when we buy

10:30 businesses we buy it debt free and cash free so why do we do that the reason is you might have two identical businesses one both with an ebitda of 10 million and both trading at a multiple of 10 times ebitda right so both worth hundred million dollars however one has 20 million dollars of debt on its balance sheet and the other has zero dollars of debt on its balance sheet so do you think both of those businesses should be valued the

10:57 same the answer is no because the one with no debt on its balance sheet should be worth more than the one debt on earth's balance sheet right why is that because well debt we have to pay that back don't we so it's a reduction to the purchase price really so that's why and the inverse is true for cash right so typically what will happen in a transaction is the previous sellers or vendors as we call them

11:21 will remove cash from the business right if they've got if they have a same principle or price right if they've got two businesses exactly the same but one's got 20 million dollars for cash on balance sheet and now they've got zero dollars of cash on balance sheet obviously the one with cash on it assuming you inherit that cash is worth more so what vendors will do and this is preferred by both sides typically is that the vendor will actually

11:43 sell or sorry they'll pay out a dividend and extract cash from the business rather than leave it in for the next seller although there are some situations where it's actually a tax incentive or it's it's better to leave that cash in for the seller because they can take advantage of uh capital gains tax incentives so it might be more favorable for them to leave it in so it's kind of a you might negotiate where it's okay to

12:08 leave cash in and you actually adjust it through the working capital adjustment which we'll talk through in a moment but that's the general principle for net debt in cash so essentially we'll increase the value of the business for any cash left in the business that's not taken out and we'll reduce the value of the business for any net debt in the business that's not i guess paid down before settlement but typically the principle is we're valuing

12:32 and we're buying businesses on a debt free and cash-free basis as i mentioned it's not always possible you know it's not always possible or practical to just remove the debt and cash from the business for example you might have tied cash tied up in the business which you need to operate ie working capital requirement which we'll touch on in a moment or with debt there might be kind of early repayment penalties which are quite cumbersome and

12:56 they might say look it's not really worth it let's just leave it in and we'll you know you can still adjust the purchase price for it but we're buying it on a debt-free cash-free basis okay so that's net debt and cash why we'd adjust for that so the next item that we want to talk about is working capital so first of all what is working capital working capital and we'll we'll touch on this in significant detail once we go through

13:20 the technical accounting sections of this course you know talking about all the different you know efforts and tax and management accounting etc we'll touch on all of this so you get a really good understanding of the fundamentals but at a very high level what working capital is it's like the lifeblood of the business if you think about it think about a business like a car a car needs fuel in it to operate so let's say you go and hire a car from

13:42 hertz or avis right they're not gonna or you buy a car from a car dealer right they're not going to give you the car with an empty tank of fuel right even though it's it's not advantageous for the dealer or or the renter to give you gas because that's a cost for them but it needs to be in the business to drive that business so working capital is exactly the same it's the cash in the business required to maintain it

14:07 for example you might need to have a certain level of inventory tied up in the business or you might have a certain level of accounts payable accounts receivable tied up in the business which you just can't exit from because you need it if you take it out the business would suffer or even become potentially bankrupt right because you can't pay your debtors they could then you know they might you know claim some of the assets and

14:31 you know your business is in trouble as a result of that so how the working capital adjustment works is it's not it doesn't work the same as net debt cash where you just calculate the value of the working capital and adjust for that what you do is you do some analysis you typically do this in fdd like financial due diligence and you calculate okay for this business obviously working capital can go up and down but what is

14:55 the normal level of working capital what does this business require you know on an average month or the average rolling for the last three to six months you know that's your average so that's assumed to be incorporated as part of the purchase price so if we're paying 100 million for this business we're assuming that there is some working capital that comes with a business just like when you buy a car for 50 000 you're assuming it's going to

15:18 come with a relatively fuel relatively full tetra petrol tank a gas tank right it doesn't need to be completely full but enough for you to drive out go home drive around right same principle with working capital we figure out what the minimum amount is the maximum amount is and the average amount is and it depends on the transaction and what you've agreed but typically it's you identify what the normal working capital amount is and then once the deal actually settles

15:46 we then do another analysis it's called part of the completion accounts if we look at the working capital of business as at settlement and we calculate what the working capital and if it is above materially the normal networking capital amount or below materially the networking capital amount there is typically an adjustment for the difference between the agreed normal amount and what it actually is and the reason is you don't want the sellers of the business in between the process where you're

16:14 negotiating it starting to extract as much cash from the business as possible like pulling out accounts receivable you know pulling out cash that's required from the business right because the business needs that so you know and this stops them from doing that because then they leave it in the business what the business requires to operate so that's what we adjust for in the working capital price adjustment so it's not the entire working capital amount it's just the difference between what it

16:39 is at completion or when it settles i should say versus what it was agreed as the normal or required amount of working capital and then finally capex is it which is a bit less common um but basically if the business has a very large capital requirement [Music] uh for example you might have a large fit out that that's under needs to be undertaken it can be argued that you know that should also be adjusted off the purchase price as well because you

17:07 know it's not part of working capital it's a large one-off adjustment that if we had just waited a little bit longer you know the the purchase price of the business would be reduced because it would have had less cash which they would have used to pay for it anyway right so it's just essentially to adjust for that um so that's the second part of this so let's go through an example same same situation where you've got 10 million

17:28 dollar times 10 times multiple so you get 100 million in enterpr headline price the business then has let's say they've got 20 million of debt and 10 million of cash so what we'll do is we'll take off 20 million for the net debt off the purchase price we're now 80 million and then we'll add 10 million for the cash retained in the business so it's 90 million dollars right so that's what we're paying for the business

17:48 and we've agreed that the the average or required working capital of business is let's say 5 million dollars which is assumed to be part of that headline purchase price then once we actually settle the business we find out that the business only has four million dollars in working capital so we're actually gonna there's a one million dollar reimbursement that the seller also has to kind of reimburse back to the purchaser so essentially what that looks like is

18:17 we're now at 90 million dollars we're going to get a 1 million credit so we're essentially going to bring the purchase price to 89 million but obviously subject to all the terms of your sale and purchase agreement or spa now finally these other matters now these are only if something occurs and it's typically in the space of indemnities and warranties and we'll touch on this a little bit later but essentially what this means is let's say you do your due diligence uh

18:47 no no issues and and the vendor hasn't really disclosed any issues all right then down the track let's say in one to two years time after you've bought the business we find out that there's a huge liability that we didn't know and the vendor didn't disclose and the purchaser has to pay for it because we bought the business it was a share sale we've inherited those liabilities we can actually claim we might be able to claim some of those under the

19:11 indemnities and warranties in the sale agreement what this does is it actually protects the buyer from things like you know bad faith not disclosing fraud things like that um anything that you do diligence and you've understood the risk of you know let's say you've identified a tax liability and you haven't adjusted it up here you're not going to be protected in the demons and warranties because you already knew about it when you bought the business this is really just to

19:36 protect things that you didn't really know about and the vendor didn't really disclose to you so you might be able to adjust your purchase price for that but it's really just going to cover any out of pocket you expense or cost that you know the purchaser has you can also take out all the seller and buyer can also take out you know indemnity and warranty insurance which instead of claiming against the seller you can just go to

19:57 your insurance agency and actually just claim that against the insurance so these ones is not typically part of your average transaction it's but the first two categories your headline price and your price adjustment so your headline price net debt uh and cash and your working capital adjustments are typically in every large transaction adjustment the other items it really depends on the on the acquisition so that's how we calculate purchase price and how we calculate the final amount that we actually pay

20:25 net debt in cash is typically done on the date that the deal completes although there's some transactions where that's not really possible like if you're buying a public company and taking it private you might actually have to do what's called a what a locked box transaction which is essentially doing it based off a current date and then regardless of what happens on completion date you just have to accept it because you know you're buying it from essentially millions of different

20:48 shareholders you're not going to be able to claim from those after the fact but for most private transactions you'll do an adjustment or you'll do another set of balance sheet accounts on the date of settlement or as close to it as possible and then do these calculations for net debt and cash working capital at that point in time okay so let's talk about the next thing which is comps analysis so this is essentially going back to this first

21:11 slide answering the question of how do we get this multiple over here right so we said in an example i gave you a business which had 10 million of sustainable ebitda and 10 times multiple on ebitda but how do we know that that multiple is 10 times right we know this from doing comps analysis so what is com's analysis is essentially looking at precedence transactions and comparable transactions which is where the comps comes from so it's basically

21:36 looking at a bunch of similar companies so you look at companies in the same industry of similar size of similar you know growth patterns and life cycles and markets geography whether they're public private so you're trying to get basically as many similar companies as the one you're trying to buy as you can now there's no such thing as a perfectly comparable company right you know just like when you're trying to sell a car right you can't you can try

22:01 and find similar models but there's always going to be some differences whether it's a you know different color different age whether it's auto manual might be convertible versus sedan diesel versus petrol you know number of kilometers you know service quality right so there are some similarities like they're both holdens or they're both you know ferraris are both fords but during the day there's no two cars that are perfectly identical and that's that's where this comps analysis really comes in so you're just

22:28 trying to find buckets and just acknowledges where the similarities and differences are and the best comps analysis so i'll show you an example in a moment but the best comps analysis are the ones that go beyond just identifying the company but really giving a lot of flavor as to as i mentioned how they're similar how they're different so outlining you know what what business activities does this company do and flagging if there's any kind of differences which might impact

22:53 the multiple for example one business might have an online presence and one might be retail only and the one that's online only would attract a higher multiple than the retail presence because that's that's in high demand so it's important to flag that kind of thing particularly to the board executives so they don't make a bad decision and assume they're going to get a higher value when they're selling their company but they fail to take into account oh

23:16 well we're not operating in the online space maybe we don't have the same you know geographical location maybe they've the competitors got prime locations we've got you know more rural locations maybe they're a much larger sized company because that typically attracts a higher multiple and we're smaller or maybe the other companies growing at a much faster profile or they've got different kind of customer kpis especially if you're like a tech or cloud sas business some of the key

23:42 metrics you want to look at is you know customer churn you know life cycle you know cost of new customer acquisitions it's kind of looking at those things and thinking big picture and going okay are there any things which might be impacting the multiple for this comparable company so how do we um so how do we do this in practice so we typically get a number of buckets and we might do that by saying okay these are the most comparable

24:04 companies these are the the next most modern comparable companies and these are the least comparable companies but we're putting it in for a comparison anyway so you can see the full picture and then how do we kind of average out those outliers and variances so we typically do that through uh we look at an average so we might take the median and then kind of average out between forward and historical multiples as well and how do we get this data so you know

24:29 typically we'll use a service like cap iq which is a premium service you need an expensive subscription to be able to access it but you know that's that's at the ebitda level but you know you can get publicly public information about for example price earnings but typically we want to do this based off multiple different you know metrics including ebitda which is a bit harder to get from public directory so you might want to get access to cap

24:54 iq if you don't or maybe your company has access to it that you can use so let's have a look at an example comps analysis so in this case we're going to look at a optical business so we could do a little bit better and there's probably a lot of information you can't actually see on this slide in terms of analyzing say well we've got the growth percentage so you can kind of see the the growth profile of each of

25:18 these businesses we've got the country but it would be good to get a lot more detail kind of about you know any other kpis which might be driving any multiple differences but as you can see here we've got a number of publicly listed in the first instance comparable companies and we've got transactions comparable transactions down the bottom but let's start off with the public companies which is often helpful because you know these are trading at any given

25:45 time so you can run these quarterly on a regular basis and see how your on a company's valued over time or your targets valued so in this case we've got different markets and we've put a lot of thought into this and said okay you know maybe some of these geographic markets aren't going to be included or maybe some of these are too retail so we've excluded some of these because we just want to focus on say service based

26:05 businesses next we've got the market cap and ev so market cap is essentially the total essentially for in a public environment essentially the equity value versus ev which is uh or the enterprise value so i don't think i actually explained that from the previous slide what the difference was so it's very simple really so headline price this is your enterprise value ev you'll see that that term passed around a lot it's essentially the value before you take into account debt and once you

26:36 adjust for net debt in cash so this item here so take away b you get to your equity value so for a private company equity value is what you pay for and in the public market they call it market cap but it's essentially the same thing as equity value it's take into account the value of debt so for example this company its net debt value would be the difference between those two numbers um so it's important to include ev because

27:05 it gives you an idea idea about the size of these companies as well right the larger the company is it might attract a higher multiple so we need to take that into account particularly if we're valuing a small company or we're trying to sell a small company we also need to take into account geography right because there's some markets which for example the us which will pay a higher premium than in say for example the australian market which

27:28 is a lot smaller maybe lower total addressable market potentially lower growth rates and so forth so in any comps analysis we typically look at the multiple on a few different basis so ev slash revenue ev ebitda net debt at the bare minimum right so but you might also look at for example ev ebit as well and we'll talk about this in the technical accounting

27:59 sections about kind of what all the differences between ebit ebitda are et cetera and as i mentioned before it's also important to include some operating kpis as well because it just helps you kind of identify okay well investors are willing to pay a higher multiple for this company because they're growing at 60 sorry at 89 percent a year kaga right that's massive growth if your company's only growing at five percent a year investors probably won't want to pay such a premium multiple for

28:27 it so it is important to take into account so the final kind of thing to to notice here is that you know to remove the outliers and in the first run what we would do is we'd kind of remove companies which don't really fit or aren't close enough anyway so there's a lot of thought that goes into that process but then on top of that to remove any outliers in this process we'll also look at the median and mean

28:51 and then we'll try and average that over you know next next 12 months forecast and and last 12 months actual in case any of that you know multiple is driven by for example acquisitions that might be distorted a little bit so it's good to take into account both help the idea is just to essentially you know find the midpoint and eliminate any distortions there so the second part is also to look at transaction comparables and this data is a little bit harder to

29:18 get and it can be distorted by things like internal normalizations which companies may not be reporting to the market and you know they might not even have to report the numbers at all or maybe the numbers are just here say right so we need to take this with a grain of salt but it is important to get a second view of public versus private transactions the reason being is there's often a a premium in publicly traded companies

29:43 versus transactions and the reason is companies which are trading at say 20 times on the public market will be incentivized to buy companies for say you know 10 to 15 times because it actually increases the value to all shareholders because if they combine businesses trading at 20 times but they're only paying 10 times for a business down here they're getting essentially you know 10 times profit on the acquisition almost instantly and that's called multiple arbitrage so we do need to take that into account

30:13 and also if we're maybe you know trading as a small business and maybe we're acquiring a business we only want to value them on this basis and not the basis of a publicly listed company as that could inflate the multiple okay so the next thing we're going to talk about is kind of what comparable multiple do we use for evaluation so i mentioned before that ev ebitda is the industry standard without knowing necessarily about kind of what industry

30:39 you're operating and all the size of the company but it's really important to take into account what industry that it is operating in if there's any kind of unique aspects to the business or industry that we need to take into account a different multiple for valuation for example financial services might be off book value or might be of profit or if you're a tech company it might be of revenue right the average company will just be off ebitda but you do need to

31:04 think about this before you go in and value the business so the other consideration is timing of life cycle so you can see this as a time access chart as well because the more mature a company is you'll just revert to this standard ev ebitda but if you're a early company typically how companies operate is as you can see revenue is this top line up here so it'll typically operate in this kind of j shape from zero starting off slow into

31:29 an ascent and then kind of rapid growth and then maturity over here but what happens with expenses is they don't necessarily start off in profit what they'll do is if i look at say ebitda for example which is your cash your cash flow proxy it will often start off in a loss so think about you know your startup tech companies they haven't quite generated the scale you know they're investing money in building the product they're busy building out teams they haven't

31:53 quite got that you know scale yet that they can operate and make a profit and it's the same reason why tech companies are valued on multiple sales is because it's assumed that you know whilst they're spending money on acquiring customers you know they're not really going to show a profit but eventually once that company hits high level of revenue high level of market penetration then they're no longer investing in customer acquisition they can start focusing on

32:18 well they've got that scale as well but they can start cutting on costs and scaling that size as well and all of a sudden the ebitda starts scaling quite rapidly so does the ebit so it's a net income but there is that delayed time factor which is you know why you might want to consider the life cycle of the company as to which kind of multiple years for your comparable valuation measure now the next few slides just to finish

32:41 off this chapter two is kind of what are the pros and cons for each of those different kind of valuation methods so we've got four examples here we've got ev sales or ev revenue same thing so it's multiple of your revenue we've got ev ebitda which is your you know the standard one that most companies use um av ebit so the difference between ebitda and ebit so ebitda is earnings before interest tax appreciation amortization whereas ebit is earnings before interest

33:12 tax so you can see the difference is depreciation and amortization so this you could get a very different result for a very capital intensive industry for example you know car manufacturing because they might show up you know for quite a high ebitda but the fact they've got huge depreciation which is a non-cash expense of course right it's not going to impact their cash flow but it's still something to take into account because eventually you have to

33:36 replace that equipment right which is why we have depreciation at all it's a reflection of the the life expectancy of the asset essentially and when we need to kind of outlay a large capital outflow in future so if you're operating in that kind of field with heavy capital capital intensive industry you might want to use ebit instead of ebitda better measure and then finally you've got price earnings so what is earnings it's a little bit misleading

34:02 earnings is actually net profit right and net profit is very easy to get because you you can go to google and look up the price earnings of a company very easily in fact i'm going to do that very quickly now let's google let's go xero price earnings actually i'm going to go zero stock and it is going to show up

34:33 it's going to show up um just a little bit of a a high level recap you can see the price earnings ratio and this is insane because it's a tech company and they haven't probably for the same reason we discussed before they're probably they're in that ramp mode right so they're in that ramp mode maybe over here where the revenue is scaling very rapidly but there's not yet in profit so zero is probably about here right because they've still got a little

34:59 bit of profit but they're not quite at that high level of maturity right so you know earnings sorry price earnings is very easy to get but the problem is it's quite misleading right because it's got a whole bunch of accounting policies in there and a whole bunch of non-cash items so okay let's go through these one by one so the first one ev sales what are the pros well it's suitable for companies with similar business model

35:22 development stage so good for early companies uh maybe the only performance related multiple available for companies with negative ebitda so as i mentioned a lot of tech companies are going to be negative ebitdas they're not really making a profit yet so how else do you value the business you can do a future cash flow but it's kind of hard to estimate and you know but revenue doesn't lie especially historical revenue so if you're doing multiple of that it's

35:44 a good way of kind of comparing it sectors where operating margins are broadly similar between companies you can kind of make an estimate on that basis companies whose profits have collapsed might be a temporary thing like covert for example um and you don't really have any ebitda to show for it so the alternative to doing that is you just take an average of the last three years ebitda and do it on that basis next is sectors where market share is

36:08 important right and maybe it's maybe it's more about gaining market share in the short term and then you can kind of once you've got that monopoly you can force out competitors limited exposure to accounting differences um cons does not take into account varying revenue growth rates right so it's important that's why we did the comps analysis right because we look at those other measures like revenue growth where you pay a higher multiple for higher revenue growth

36:30 because in three years time your company is going to be worth a lot more money um and a lot of you know a lot of costs kind of scale with scale down with growth which means you actually get profit at large scale which you might not get at a small scale uh another con it does not address the quality of revenue you do that in dd that what is quality of revenue so it's like recurring revenue you don't want it

36:51 too concentrated either right if you've got in a couple of clients and you lose a client well there goes all your revenue um you want to be recurring so if it's a short-term contract for your revenue like a six-month contract or two-year contract that's not good because you buy the business two years there goes your revenue again so it's looking at things like that um does not address profitability issues right i think this one's really probably the

37:13 most important point out of all of these and i think whilst the principle is true that you know especially for companies that do scale and you know ebit's not necessary ebitda is not necessarily the best measure quite yet but i think that's gone a little bit too far a little bit excessive especially lately if you look at companies like tesla they're getting to a mature stage they've been around for like you know 15 years now they're at a mature stage and they are

37:40 just absolutely hemorrhaging cash so let's just quickly look at tesla's price earnings like at the end of the day at some point in future you're going to need profits for the business otherwise why would you own the company right you can accept it for a short amount of time because you're expecting revenues to grow in future and then receive profits in future but if you're never going to receive profits why are you investing this company and i

38:08 think some people are forgetting about this and you know look at this 400 price earnings that means essentially if earnings stay the same you're essentially not going to get your money back from dividends for 400 years but that's before taking into account tax which is just insane right so just keep that in mind um and different revenue recognition rules between companies okay and then let's go to ev ebitda what are the pros and cons and as i mentioned

38:38 before this is the baseline in in industry in finance um if you're not sure which multiple to use just rely on ev ebitda because there's a high chance it is going to be the right one so it incorporates profitability so really important revenue is important but so is your cost base right because if you're losing money you're going to go to business right so your cost structure is important as well and your profitability is important number two most businesses are ebitda

39:02 positive so it widens the universe at number three ignores the most significant accounting differences arising from goodwill so you might have some other accounting adjustments which are below ebitda level like in net profit for example depreciation is a you know a non-cash expense so you could be a very profitable business bringing a lot of cash uh but it's not reflected in earnings because of depreciation right and that's that's just one example there are many other examples which could

39:30 affect it as well uh number four relatively limited exposure to accounting differences so ebitda is not perfect but it's not bad like that's why it's universally used is because it can be used to compare most companies fairly well and it is an okay proxy for cash before tax not in all situations but it does give a better indicator than net profit and ebit for what your cash flow from the business which is super important warren buffett says cashing cash is king and it

40:00 is true because if you get a feel as to kind of how much profit can be distorted by accounting variances which we'll really get into in that in the later accounting and financial reporting section of this course you'll see why it's so important and now the downside so it ignores depreciation capex so i mentioned before especially if you're in a capital intensive industry depreciation whilst not a cash flow it can be important over time because it's

40:27 kind of like building up a buffer as your asset depreciates that's a cost but if you put that aside it's kind of like we're expecting to put that towards our you know reinvestment in the asset in five years time or ten years time whatever the effective life is it's reflected on the accounts right and then in ten years time you spend a million dollars on on getting a new asset at least you've been reflecting that over

40:50 the past ten years wherever with ebitda you're not really reflecting that number two ignores tax regimes and tax profiles look i think the reason why we do this excluding tax is because some businesses have different tax profiles like some have might care might have carry forward losses some might have you know international tax arrangements like apple where they're only paying eight percent overseas versus thirty percent in australian company um right so it's it is important to kind of

41:19 and that's and by removing that you've now got this universal measure which can be easily compared against almost any company in the world regardless of where it's located regardless of what it does that's why we do it but you just need you do need to remember the tax cost is after ebitda as well uh it does not take into account varying ebitda growth rates well yeah that's why we do the comps analysis and add in those extra data points so we can

41:40 compare those as well uh inconsistency of treatment within ebitda of joint ventures and other unconsolidated affiliates within different reporting environments so we'll touch on this in our technical accounting section in the course later on and other accounting differences such as revenue recognition capitalization policies finance versus operating leases so yeah i did mention that you know we do need to be wary of what are the accounting impacts on ebitda so one example which i'll draw your attention to is capitalization

42:08 policies so tech companies in particular they can sometimes capitalize expenses either for you know r d or maybe labor on building their product and that's actually you know some some of them do it quite aggressively so you actually some of them actually hide their true expenses um so something to be careful there another one to be careful of which is quite a recent issue which didn't used to be an issue is the iphone 16 leases issue

42:40 and yeah we'll touch on that in the financial reporting videos but a really important one to understand because it used to be that ebitda would include lease expense that would be fine you know the cash that you pay if you're in a lease especially if you're a you know retail heavy environment it would be reflected in your ebitda but now with this new if for a 16 it actually forces you to take out your lease expense

43:03 below the line and treat most of it as amortization which is below ebitda so you know what's the impact of that it's going to impact multiples paid for businesses really because it's going to inflate ebitda it's going to reduce multiple or it's going to trick people into paying a higher price for businesses than they would have otherwise so just something to be really careful of as well and then finally ebit so quite similar to ebitda the only difference is

43:29 depreciation amortization so the benefit of using ebit is well at least it takes into account depreciation and also now it mitigates that for a 16 issue so potentially even over the next few years is going to gain a bit more kind of commonplace to use just because it does kind of address some of those issues but you know depreciation at the end of the day it's not a cash item so just be careful with that one

43:55 we really want to know what's the cash position and cash generation of a business right so depreciation can distort that and then finally price earnings i mean it's very easy to get this data as i showed you got that in two seconds but getting the ebitda is a little bit trickier and also a bit subjective as well so but the issue with using price earnings is well there's so many accounting policy impacts on it that it there's

44:20 sometimes just a very big disconnect between cash flow and price earnings so i use it as a very very high level indicator of a company's valuation but to me i try and stay away from it and i try and calculate what the ebitda is myself and value it on that basis instead okay so that's the end of chapter two in the next video we'll cover off ebitda and underlying earnings and and why it's so important to really understand what

44:45 ebitda is and how do we calculate underlying earnings so thanks for watching i'll see you next video