What is a valuation?

At its simplest level, the valuation of a business is the value of the future cash flows the business can generate. For most small to medium sized businesses, it is generally assumed that ‘past financial performance (or earnings) are an indicator of future financial performance (or earnings)’.

In consideration of this, the way in which a business’ earnings are measured is of fundamental importance when assessing the value of a business. As is expected, for most businesses, the reported net profit (as shown in the profit and loss statement) is a poor measure or gauge of the business’ real commercial earnings and performance. Accordingly, in order to assess the business’ true commercial earnings a number of adjustments (or add-backs) need to be made. These adjustments may be made in consideration of a number of items, including:

  • Abnormal expenses or incomes (for example, one-off legal fees incurred by the business)
  • Non-commercial expenses (for example, motor vehicles owned by the business, however used by the shareholders for purposes other than operating the business)
  • Related party transactions (for example, management fees paid to a company also controlled by the shareholders of the business under analysis)

Beyond those adjustments (or add-backs) detailed above, consideration should be made as to the best measure of earnings for the business based on its industry, reliance on capital assets and size. Outlined below are the four most common measures of earnings that are applied when assessing the value of small to medium sized businesses, with commentary provided on their applicability to various industries and business types.

PEBIT

PEBIT is Proprietor’s Earnings Before Interest and Tax. In practicality, this means it is a measure of what the business is reasonably assessed to return in total earnings to one working proprietor (including their salary and superannuation) after making standard adjustments (or add-backs) and after removing interest expenses.

This measure of earnings is mostly applicable to small businesses with revenues of under $1 million, where the proprietor plays an active role in the day-to-day operation of the business. Further, businesses that lend themselves to a PEBIT measure of earnings normally have a requirement for regular upgrades of their physical asset base.

A good example of a business that would be suited to PEBIT as a measurement of earnings would be a small trucking business operated by an owner-driver.

PEBITDA

PEBITDA is Proprietor’s Earnings Before Interest, Tax, Depreciation and Amortisation. In essence, this measure of earnings is the same as PEBIT, however depreciation and amortisation expenses are also removed during the adjustment (or add-back) process.

As with PEBIT, this measure of earnings is mostly applicable to small businesses with revenues of under $1 million, where the proprietor plays an active role in the day-to-day operation of the business. In contrast to PEBIT however, PEBITDA is generally used in circumstances where there is limited need to constantly update physical assets that are used by the business.

A good example of a business that would be suited to PEBITDA as a measurement of earnings would be a small HR consultancy business which is operated out of a small office with minimal use of physical assets.

EBITDA

EBITDA is Earnings Before Interest, Tax, Depreciation and Amortisation. This measurement is identical to PEBITDA, however it includes a market salary expense for the role of the working proprietor.

EBITDA is mainly applicable to businesses with revenues of over $1 million that do not have a major reliance on physical assets.

A medium-sized accountancy practice would be well suited to EBITDA as a measurement of its earnings.

EBIT

EBIT is Earnings Before Interest and Tax. This measurement is identical to PEBIT, however includes a market salary expense for the role of the working proprietor.

This measure of earnings is generally most applicable to larger businesses (with revenues of over $1 million) that have a large physical asset base integral to the day-to-day performance of the enterprise.

A great example would be a truck company that relies on a large fleet of trucks that need to be updated periodically in order for the business to continue to trade.

Putting it All Together

The following example shows each measure of earnings detailed above in its application to a hypothetical business’ profit and loss statement:

Income

$500,000

Less Operating Expenses

$300,000

Reported Net Profit Before Tax

$200,000

Plus Adjustments (Add-Backs)

$50,000

Plus Proprietor’s Salary and Superannuation

$50,000

$300,000

PEBIT

Plus Depreciation and Amortisation

$50,000

 

$350,000

PEBITDA

Less Commercial Salary and Superannuation for Proprietor

$110,000

 

$240,000

EBITDA

Less Depreciation and Amortisation

$50,000

 

$190,000

EBIT

As can be seen, each measure of earnings presents a significantly different result with a gap of $160,000 between the highest result and lowest result. Knowing which measure is most applicable and accepted based on the business at hand will have a major impact on any assessments of business value that are made.

Find Out More

Quinn M&A has an expert team of business valuers and transactional advisors that can help you. Contact Quinn M&A on 02 9223 9166 or email [email protected] to find our nearest office.