Comparability in businesses is virtually an oxymoron. Every business is different, including franchised businesses. Having owned a franchise personally, I can tell you that although our services were the same as other franchisees, our employees, our clients and our profitability were certainly unique.
As you evaluate various businesses for the purpose of acquisition, although there is recognized differentiation, still there should be consistency in how profitability of businesses is calculated. Using a homogeneous method of profitability comparison, will allow you to fairly judge the value of businesses, despite their differentiation.
The comparability standard we use in general terms is: Total Owner’s Discretionary Cashflow. Specifically, we use EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), adjusted by owners discretionary expenses. If you are not familiar with the term EBITDA, don’t worry, any financial adviser you employ in the due diligence process will be. Effectively you are evaluating the business profit on a pre-tax, pre-interest, pre-depreciation and amortization basis. Add to that the owner’s salary and other non-business essential perks and you have a picture of the business’s “Total Owner’s Discretionary Cashflow”.
Having arrived at the discretionary cashflow figure, you can then calculate your own personal financing costs to acquire the business, plus any capital requirements you forecast the business to need (i.e. additional equipment and inventory, or capital for growth purposes). Going through the above exercise on all businesses you evaluate will allow you fair comparability across various industries.
Profit alone however, is not the sole indicator of total value. Although profit is typically the focal point of what buyers are looking for, the income statement analysis should be accompanied by an analysis of the balance sheet. Given comparable discretionary cashflow, a balance sheet with substantially more assets will attract higher value. Why? The buyer will have more tangible assets to continue running and growing the business, and any lenders used in the acquisition process will be happier to lend with a stronger asset base.
What are owner’s discretionary expenses? Basically any expense that is not required to operate the business is a discretionary expense and should be added back to the cashflow of the business. Examples of discretionary expenses would include personal vehicles, personal travel and other entertainment that are non-business related. We’ve seen everything from the building of a vacation home in Belize to girlfriends in Las Vegas that ended up as ‘business” expenses. It’s important to weed out the discretionary, from the truly legitimate business expenses, in order to fairly understand the full profitability of a business.