Is EBITDAC a valuation driver or a gimmick to sell mugs?
EBITDA is a key measure of business performance and a well-established cornerstone of transaction valuations, where it is viewed as a proxy for operating cash flow to which a multiple is applied. In a financial diligence process, much of my focus tends to be on assessing normalised EBITDA.
In 2020 a new twist on the term emerged, “EBITDAC”, meaning earnings before interest, taxes, depreciation, amortisation and coronavirus.
I first saw it on a mug on a popular ecommerce site, but it was also being discussed (fairly disparagingly) in the broadsheets when a number of listed companies presented it in their results announcements, and banks were taking it into consideration in the context of assessing covenants. At the time I wondered to what extent EBITDAC would be adopted for the purposes of business valuations in a transaction context and what challenges this would present.
The use of an adjusted EBITDA measure relies on the ability to adjust for the impact of a non-recurring event or a permanent change in a business (i.e. adjustments that are separately identifiable and quantifiable), thereby creating a robust basis for assessing ongoing trade.
In May 2020, when all of us were still reacting to the new COVID-19 environment, I considered a number of challenges, for example:
- COVID-19 is likely to have impacted the business in numerous ways, some of which may be known and quantifiable but many of which are unknown and unquantifiable
- The situation is constantly evolving and therefore the impact is likely to change over time
- Many sectors will be facing a permanent change to their business models meaning that what was normal in the past will not be normal in future; and
- The new normal has not yet been fully realised and is, to a significant extent, still an unknown.
Was I right?
Revisiting this almost a year later, I think my expectation has held up. EBITDAC has been on the agenda, but more as a way to think about how coronavirus has impacted historical trading than as a valuation driver. In general, management teams have found it easier to isolate and quantify the impact of the pandemic on costs (such as less travel and property cost savings) than revenue (for example the new customer wins that were delayed or the extra churn that arose). In addition, many companies expect a portion of the cost saving to persist, resulting in a permanent benefit to EBITDA, where the ongoing revenue impact is still unclear.
In any event, most CEOs would argue that the last 12 months EBITDA is not the right measure of underlying earnings but I’m not sure that EBITDAC is right either. In fact, if a business has been turned upside down by the pandemic then any historical measure is unlikely to be particularly informative of underlying earnings. So, as well as historical EBITDA we often look at:
- Projections – if future revenue is visible and there is clarity of the cost base then analysis of projected performance might be helpful. But evidencing the future is difficult at the best of times, and in many businesses there is still uncertainty about how and when life will return to “normal”. This is why building resilience into your business is so important.
- Annualisation – if there is evidence that some sort of normality has returned then annualising a recent period (eg the last three months) or highly visible future period can be informative, although care needs to be taken with seasonality.
- All of the above – the impact on businesses has been varied, and looking at the results in a number of different ways is likely to be the most informative way to assess trading.
As to my other predictions from last year? I expected to see earn-outs as a way to bridge expectation gaps around future profitability, and completion accounts used to provide additional buyer protection. Has this happened? Not really. The level of uncertainty in some businesses is so significant that an earn-out simply doesn’t fill the gap - these businesses are almost un-investable and so the completion mechanism is a moot point.
Having said this, where there is good visibility on future profitability, investor demand for these businesses is such that sellers are able to specify a deal structure with certain considerations and a locked box completion mechanism. This has been particularly evident in the tech sector, where the private equity investors have been making up for lost time; I wrote about this more last month. Read: Tech and media 2020: Growth and performance in a year of COVID-19.
I have seen pandemic linked balance sheet items taken into account in assessing the equity value of a business. The equity value is the enterprise value (often a multiple of EBITDA), adjusted for the level of cash or debt in the business. Companies across most sectors have taken action to manage cash, assisted by government support measures with consequential impacts on working capital and cash/debt. As such, working capital in much of 2020 and 2021 will not have been (and may continue not to be) “normal”. We typically see deferred liabilities, such as VAT liabilities and creditors where payment terms have been stretched, classified as debt-like, reducing the equity value.
Other adjustments to working capital are also examined, issues such as collecting debtors and, more challengingly, permanent changes in terms of trade. We will discuss working capital themes further in our April Corporate Finance Market Update. Sign up here to receive a copy by email.
There are clearly implications for transaction mechanisms that will need to be carefully considered and monitored as market practice evolves. Over the longer term, as we get better visibility on the impact of the crisis, EBITDAC may become clearer and therefore more helpful.
So, although not just a gimmick on a mug, at the moment, EBITDAC is unlikely to be an effective measure of business performance or a proxy for cash generation, and therefore it may not work well as a transaction valuation driver.