What are some common mistakes made in Business Valuation?

Murray Yeates from Tabak Waikato answers your questions.

One of the most common mistakes made when valuing businesses using methods such as the capitalisation of earnings, capitalisation of cash flow is:

Applying EBIT Multiples to EBPITDA and EBITDA earnings

To explain this better I will go over some terminology.

What is the difference between EBIT, EBITDA and EBPITDA?

EBIT represents operating earnings before interest and taxes, but after depreciation and amortisation. Where EBITDA does not consider the company’s capital expenditure needed to sustain its business. EBIT normally uses depreciation as a proxy for capital expenditure (capex).

The use of EBPITDA or EBPITD is commonly used when valuing small business, this like EBITDA does not consider the companies capital expenditure, it also excludes any proprietors (owners) income.  Technically this should only exclude one proprietor’s income however in practice this is not necessarily what happens.  (It is important to understand what has been included or excluded).   It is also common to see earnings represented as EBITDA but have the proprietors earnings removed.

Doing this could over value the business by 20 to 50%

Once you have established the earning for the business the basic principle of this valuation approach is to apply a multiple to the earning, this multiple reflects the risks underlying the earnings together with growth prospects.

This is where mistakes happen, most practitioners do not have sufficient information, knowledge or skill to calculate what the correct multiple should be, so they use a rule of thumb approach. In most cases these rules of thumb are based on EBIT earnings multiples which may be 3 or 4.  Because they are valuing a small business they have assessed the earnings of the business based on EBITDA or EBPITDA. The end result is they apply this EBIT multiple which will likely end up over valuing the business by 20 to 50%.