Valuing Agencies Using Multiples of EBITDA
Multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) has been used for various business valuations, investment decisions, and loan arrangements for many generations so there is nothing new about it (barring the somewhat creative derivatives companies deep in debt and unable to grow organically are now creating). I find that most agency owners though do not have an adequate understanding of EBITDA or an EBITDA multiple valuation. It sounds simple but nothing simple is connected to this methodology. The fact that it sounds simple but is not simple makes this methodology very, very dangerous.
First, because using this methodology is complex, most agency owners do not have the education to know how to use it. This is not a critique of their IQ. Unfortunately, because it sounds so simple, they think they know how to use it.
Second, even so-called experts have a tendency to not make the right adjustments using this methodology. Even big-time firms using this method have a tendency to use it incorrectly. Part of the problem is this method was never designed for financial service firms, which includes insurance agencies. It was designed for capital intensive firms such as utilities that have to invest heavily upfront in physical infrastructure.
Using it for firms like insurance agencies (or especially an insurance company) is risky because to use this method correctly requires several crucial subjective factors that are not easily apparent in the formula. These factors are not any of the letters: E, B, I, T, D, or A. In other words, the formula makes it sound as though the only calculation is earnings excluding interest, taxes, depreciation and amortization but this is absolutely, 100 percent wrong. Other factors include risk of the operation and growth rates. These extremely important factors are supposed to be included in the “multiple.” In other words, if the EBITDA is supposed to be multiplied by five, but the firm has no risk and will grow 20 percent annually forever, the multiple should be adjusted – probably to a 10-plus.
The huge mistake agency owners most often make is they think the multiple is a pure comparable. In other words, are agencies selling for five or six or seven times EBITDA? That is the wrong approach. Extremely simplified and still partially wrong, but less wrong, the question might be asked, “Are agencies that have high risk but high organic growth selling for five or six or seven times EBITDA? What about agencies that have low risk and low organic growth?”
The best appraisal firms have objective or at least less subjective methods for making these adjustments but agency owners doing their own appraisals do not (and neither do many people completing agency appraisals if truth be told).
Third, the actual complexity of this simple looking method is used to take advantage of sellers. For example, the other day I heard of a well-known buyer paying 10 times EBITDA. They may have paid 10 times EBITDA, using the seller’s unadjusted EBITDA, but they did not come close to paying 10 times the applicable EBITDA. Again, the simpleness of “EBITDA” leads to mistakes. I find most agency owners think only one earnings number can be calculated using this formula. But that is wrong. When analyzing an agency, multiple “E’s” may be calculated. There is the agency’s unadjusted earnings, there is the buyer’s applicable earnings, there is the seller’s adjusted earnings, and other variations may be applicable. So what “E” is being used when you hear someone say that so and so sold for eight, nine, or 11 times EBITDA? More than once, 11 times EBITDA has really been equivalent to five times the truly applicable EBITDA.
Some buyers therefore make sellers think they are getting far better deals than they are really getting. The result is that some sellers are leaving money on the table. They are being taken advantage of by people that truly understand how to use the EBITDA methodology.
Fourth, for regular agencies that are not public and not going public (I’d argue the brightest people within even the public environment understand that EBITDA is not applicable there either ), EBITDA is not that important relative to this aspect of value, period.
In the chart, there is an example of four different scenarios for the same agency.
(Do not take that to mean a multiple should be applied to free cash flow because it should not be. What I am showing in the chart is simply to exemplify the difference between EBITDA and free cash flow. The reason free cash flow multiples do not exist is because the people that use this earnings stream correctly also use much more sophisticated valuation methodology.)
My goal in writing this is to help agency owners avoid making mistakes when buying an agency or selling their agency. Obviously, this is a short article and much more consideration and knowledge is required but hopefully this article at least helps the readers ask the right questions.