What a business is worth is a financial, accounting, commercial or business question. It is not a legal question. Make a false, misleading or deceptive statement or move in reply to the question, and it may become a legal issue. It has recently become a legal issue for MySpace in the dispute over whether the valuation and sale price of US$580 million was in order.
Better understanding of business valuation methods is a need in many circumstances. It helps both reduce the risk of disputes and misunderstandings as well as increase returns and the chances for success for all parties.
A prudent business seller or buyer can use financial indicators (such as industry conventions, multiples and ratios) as a part of a toolkit to negotiate an acceptable business sale price. EBIT multiples are a common indicator. Elsewhere we have examined business valuation with price earnings multiples.
Major valuation methods are based on:
- earnings (eg capitalisation of future maintainable earnings or discounted future cash flows),
- assets (going concern value or realisation value), or
- the relevant industry (eg market value or rules of thumb).
EBIT definition and internet deals
The valuation method overviewed here is EBIT, an earnings based valuation method.
EBIT is an acronym for earnings before interest and taxes. Some of the most common expenses deducted from sales and other income (except interest earned) before arriving at EBIT are cost of sales, distribution costs, marketing and selling costs and administration costs.
Generally the lower the costs the higher the EBIT and the higher the valuation of a business.
For a related measure known as earnings before interest, taxes, depreciation and amortisation, EBITDA, depreciation and amortisation expenses are not included in the costs.
An illustration of the use of EBITDA multiples appears in the last column in the accompanying table. The table lists major internet deals since 2004, including the MySpace deal. The table appeared in a recent Financial Times article reviewing the copyright issues faced by Google in its acquisition of YouTube.
Valuations based on EBIT or EBITDA calculate the enterprise value of a company.
EBIT case study in Australia
As for experience in Australia, Appendix C of the August 2006 Independent Expert Report by Lonergan Edwards Associates Ltd provides an example of the use of EBIT multiples in a company takeover. It also provides a useful case study of valuation of IT companies in Australia
The report was prepared on instructions from VeCommerce Ltd (an Australian company with voice recognition IT first identified by Scitec Ltd in 1997) to respond to a takeover offer by Salmat Ltd which is also an Australian company and which has operated for 27 years and has over 4,000 employees. After 25 years as a privately held company, Salmat Ltd (ASX Code: SLM) listed on the Australian Stock Exchange on 2 December 2002.
Lonergan Edwards Associates Ltd conclude that Salmat Ltd’s offer of $2.30 cash per share is fair and reasonable particularly in reference to Policy Statement 75 of the Australian Securities and Investment Commission. Salmat Ltd’s offer values VeCommerce Ltd at about A$28.7 million.
On 27 October 2006 Salmat Ltd moved to compulsarily acquire the remainder of VeCommerce Ltd shares having already acquired 95.05%.
That’s the factual background. What about the valuation? Let’s focus just on what it says about EBIT in Annexure C (there are additional comments in paragraph 73 of the report). Annexure C of the report lists EBIT values of companies which Lonergan Edwards Associates say are involved in similar activities to those of VeCommerce Ltd.
Annexure C lists US and European listed companies with speech recognition technology and interactive voice response systems and with very high 2006 EBIT multiples (eg Nuance Communications, Inc at 23.4 and InterVoice-Brite, Inc at 21.3). The annexure also lists several Australian software solution providers with relatively lower 2006 EBIT multiples (eg Dimension Data Holdings at 10.1, Oakton Ltd at 12.9, Technology One Ltd at 12.0, andIntegrated Research Ltd at 8.3.
Annexure C and paragraph 73 illustrate the existence of geographic, temporal and industry variables in EBIT multiples. They state or suggest:
- the need to identify an appropriate multiple with comparable companies;
- the need to consider the differing profiles and growth prospects between the company being valued and those considered comparable;
- that it is appropriate when valuing controlling interests in a business to make an adjustment to incorporate a premium for control;
- the need to properly treat earnings from any non-trading or surplus assets when estimating maintainable earnings;
- higher EBIT multiples for US/European companies versus Australian companies; and
- higher EBIT multiples for speech recognition technology versus say an accounting program provided by the Queensland-based Technology One Ltd.
How to calculate an EBIT multiple for your business
To determine the value of your business on the basis of EBIT, the first step is to locate a similar business or company. This is illustrated in the following very simplified example.
- Locate a company which is typical or representative of the industry in which your business operates.
- Assume that company has 1,000,000 shares at the current value of $27 per share. Say the company also has a debt of $5,000,000 and surplus funds of $2,000,000 and an EBIT of $1,500,000.
- Assume the EBIT multiple for businesses in that particular industry is 20.
- The EBIT multiple is 20 based on: (1,000,000 shares x $27 + $5,000,000 – $2,000,000) / $1,500,000.
- Now take your business and from its last financial statement work out your EBIT.
- Multiply your EBIT by 20 to arrive at your business value on the basis of EBIT.
EBIT should not be used as the sole method to evaluate a business or company. There are also numerous other valuation methods which need review. An example of a trap for young players is that an enterprise may be heavily leveraged and may be losing money when interest or taxation are taken into account.
Selecting the most appropriate EBIT multiple is crucial. Consider the following when using an EBIT multiple:
- EBIT multiple information may not be reliable;
- EBIT multiple information is only one of many valuation methods and may not be the most appropriate in a specific situation;
- market valuation of a business may be determined by other factors, formulae or considerations. It may not be EBIT at all or not merely on EBIT. For example, it may be the level of debt to equity and the accompanying credit risks; and
- even with EBIT, debt levels of your business may vary during the year under review and therefore the use of an EBIT multiple may not give an accurate valuation of your business.
Ultimately working out EBIT and selecting an appropriate EBIT multiple is a job for a specialist or professional. It is not a job for a lawyer. It is also not a job for a non-financial business executive who is not properly briefed. But it is useful for everyone to be aware of how the numbers are derived.