Monday, 19 September 2011

Finance for Managers - Earnings-Based Valuation - EBIT Multiple

The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate.  In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's.  Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders.  How is this possible?  The answer is twofold:  the manner in which they are financed, and taxes.  If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line.  Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities.  And taxes reduce bottom-line earnings.

Consider the hypothetical scenario in table 10-a.  Notice that the two companies produce the same earnings before interest and taxes (EBIT).  But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000).  This dramatically reduces its earnings before income taxes relative to Amalgamated.  Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company.  The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process.  Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization.   Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms.  By using EBITDA in the valuation equation, this potential distortion is avoided.

Table 10-a

Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation

                                                         Amalgamated     Acme
Earnings before Interest and Taxes      $757,500        $757,500
Less:  Interest Expenses                      $110,000        $350,000
  Earnings before Income Tax              $647,500        $407,500
Less:  Income Tax                               $300,000       $187,000
  Net Income                                       $347,500       $220,500



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