Investors frequently value businesses based on a multiple of adjusted EBITDA (earnings before interest, tax, depreciation and amortisation) for the trailing twelve month period.
The output of this calculation represents the headline price (i.e. enterprise value) paid for a business. This isn’t the ultimate price paid (as explained in the enterprise value to equity value price article).
However, you will note that I stated ‘adjusted’ EBITDA as opposed to reported EBITDA.
So what’s the difference between the two?
Reported EBITDA represents the number presented within monthly Management accounts, whilst adjusted EBITDA is the output figure post quality of earnings adjustments being made (i.e. adjustments to earnings for exceptional items and/or inappropriate accounting treatment).
Adjustments can arise for a number of reasons. For instance:
- There may be one-off sales that are unlikely to repeat in future periods.
- Management may have made a genuine error in the preparation of their management accounts.
- Management could artificially boost profits in the year of sale (e.g. by creating an unnecessary accrual in the prior year and releasing it in the year of sale).
When a corporate or private equity buyer is considering acquiring a business, they will typically approach advisory businesses such as the Big 4 accountancy firms (KPMG, PWC, Deloitte and EY) to perform financial due diligence. As part of this process, these firms will prepare ‘quality of earnings’ or ‘underlying earnings’ analysis to better inform their client of the quality of the earnings reported by the vendor business.
Quality of earnings (‘QofE’) adjustment examples
There are too many potential quality of earnings adjustments to go through them all, but a sample of adjustments are listed below:
- A one-off termination payment of £0.2 million was received in FY19. In this scenario, there are no associated costs and therefore the QofE adjustment would reduce reported EBITDA by £0.2 million in the period.
- An accrual for bonuses of £0.3 million was created in FY18 and then released in FY19. In this scenario, an accrual was created in the prior year, but never used. This results in a £0.3 million expense in FY18 and then £0.3 million credit in FY19. In this scenario, we would make adjustments to reflect the scenario as if that accrual was never made.
- Legal costs of £0.1 million were incurred in FY19 in relation to a customer dispute, but the business has never historically experienced such a claim. In this scenario, we would think about adding back the £0.1 million costs
Why are quality of earnings adjustments important?
In this example, our fictional business was showing reported EBITDA growth of £0.3 million between FY18 and FY19 (10.0% growth). However, on an adjusted basis, the EBITDA has actually decreased by £0.4 million (12.0% decrease).
Thinking about the enterprise to equity value bridge, if we assume a 10x EBITDA multiple, the difference in headline price could be £4.0 million.
- £3.3 million * 10 = £33,000,000
- £2.9 million * 10 = £29,000,000
- Difference = £4,000,000