Selecting an operative timeframe for valuation

John Wagner

Traditional performance indicators such as EBITDA, OPEX, and COGs are all used in valuing lumber and building material businesses, whether they are lumberyards, retail operations, distributors, or manufacturers. That said, the most common method valuing companies is the tried-and-true “multiple of EBITDA” basis. That multiple is calculated as Total Enterprise Value (the purchase price) divided by EBITDA.

The multiple of EBITDA valuation method is so tried- and-true because EBITDA is widely viewed as a proxy for cash flow, and this method is preferred over, say, basing a company’s value on a multiple of top-line revenue or discounted cash flow. Yet, even when applying the multiple of EBITDA method, a company’s value depends on the operative time frame that an acquirer will agree to when examining financial statements to determine the EBITDA on which the multiple is applied. Let’s take an example: If the operation for sale is in a high-growth phase and located in a great market with strong future prospects, that company could be valued using future revenues, or at least expect some consideration for them. This is especially likely if the company has predictable, recurring income, long-time stable customers, and a strong brand.

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By comparison, a company that is showing flat growth or slow growth would probably have its value based on historical financial performance. For slow-growth/flat-growth companies, acquirers like to look back three years. Some buy-side analysts will average the EBITDA across a span of time, and apply a multiple to that average number.

Now, here’s a third scenario: If the company for sale is having a relatively good year, taking advantage of strong building or demand in their service regions, it can be argued (typically by your investment banker) that the acquirer look just at TTM (trailing twelve months) to determine the EBITDA used to determine value. If the TTM EBITDA (wow, we are throwing around the acronyms now!) is showing a growth trajectory, and your performance convinces the acquirer that this growth will continue, it’s fair to ask for a slight premium on the multiple to reflect your good prospects. A slight premium could be moving from, say, 6X EBITDA to a 6.5X EBITDA.

That 0.5X “premium” can add up to be real dollars, either in the pocket of the seller…or out of the pocket of the acquirer. So, expect some (shall we say, high-functioning) conversations, when the seller and acquirer meet to determine exactly what the multiple is. Let’s do the math to determine the implications. For ease of calculation, let’s say your company has a $2 million EBITDA over the trailing twelve months. A 6X on that EBITDA would value your company at $12 million. But if you successfully argue that there should be a slight bump of 0.5X in the valuation calculation, citing your growth trajectory, that $12 million purchase price turns into $13 million (6.5 x $2 million = $13 million), a million-dollar incremental bonus.

Okay, now let’s say that you cite your TTM performance, and argue for a slight premium on the multiple of EBITDA paid for your company. (There’s never any harm in asking, but have your investment banker build the case, based on empirical evidence and financial statements. Don’t just say it’s a gut call!) Your potential acquirer might look over your request and offer an earnout, saying: “Tell you what: I agree with you that your company could be worth 6.5X, but I’d like to hedge my risk. I’ll pay you 6X on your TTM EBITDA today, and then I’ll pay you 6.5X on the incremental positive EBITDA over the next twelve months. If your company performs as you say it will, then you will end up with a higher purchase price. If you don’t grow as fast as you project, then you have to settle for the 6X we paid at closing.”

This is a perfect example of how the earnout serves as a risk allocation vehicle that stakes, at least in part, the total enterprise value paid for your company to your future growth, while also fairly rewarding your proven historical performance.

Note that some earnouts go for more than one year. Sometimes they go as long as three years. But longer duration earnouts mean that you share risk with the acquirer, since there is no way to guarantee what will happen to the economy over an extended period of time.

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