Making Sense of the Sales Multiple

We’ve all heard that companies are valued by, and sell on, a “multiple.” The talk at the club and trade conference quickly moves to “who sold for what multiple.” We hear the multiples, but we almost never hear the definition of earnings used or important elements such as deal terms.

There is much confusion about what constitutes earnings. A recent Wall Street Journal article said that “there are a host of names for earnings and there is no uniform standard by which to understand them, causing much confusion among investors.” So when “multiples of earnings” are mentioned, the types of earnings should always be clarified and defined.

This article explains various types of “profits” used and the definitions of each. With an understanding of terms and definitions, we can begin to put any particular business sale multiples in proper perspective.

To begin, review the 2007 income statement for XYZ Company at right. How much profit did XYZ make in 2007? This is a trick question.

Profit comes in many forms: gross profit, operating profit, net profit, taxable profit. Earnings can mean the same as profits. The names and definitions are almost endless. Below is a list of commonly used terms that refer to profitability.

Now, imagine you are at your country club and Jack Taylor tells you for the 10th time this year that he sold his company for 10 times profits. To his surprise, you ask him what he means by profits. After he gives you a flip answer like “You know, the green stuff you put on the table in Vegas,” you inquire as to what type of earnings. He probably doesn’t even know himself. But you will.

If he sold for 10 times his after-tax profit, then the price was $600,000. We see on the accompanying table that XYZ Co. reported pretax profit of $60,000. When we look at the income statement and footnotes, we see that adjusted seller’s discretionary cash flow (SDCF) was $365,000. Consider this number and the definition of SDCF, and you might come to believe that Jack Taylor didn’t obtain the premium he boasts of.

We could estimate that this company generates $300,000 in annual after-tax income to the owner, assuming that 2007 was a typical year, except for the lawsuit expense, and that his company was not a C-corporation and thereby subject to double taxation. This is pre-debt service, so as long as the owner used leverage, his take-home would be less. Again, it does not appear that he sold for a premium.

In summary, next time you hear a sale multiple, you’ll know that it tells you almost nothing unless you know the definition of profit used. Similarly, the sale price is almost meaningless unless you know the terms.

Various Types of Profit

• Gross profit: revenues minus direct expenses (often referred to as cost of goods sold)
• Operating profit: gross profit minus operating expenses (often referred to as sales, general and administrative expenses, or net operating profit)
• Pretax profit: operating profit minus all expenses (except taxes)
• After-tax profit: profit after all expenses have been deducted, including taxes
• Net profit: see After-tax profit
• Profit: general term for profitability, e.g., gross profit, net profit
• Earnings: profit, generally net profit
• EBIT: earnings before interest and taxes
• EBITDA: earnings before interest, taxes, depreciation and amortization
• Seller’s discretionary cash flow (SDCF): EBITDA plus owner compensation and all non-recurring expenses and those unnecessary for ongoing business operations
• Owner earnings: see SDCF
• Taxable income: see Pretax profit
• Normalized earnings: adding back to profit all excess owner compensation (salaries that are not “fair market”) plus all non-recurring expenses and those unnecessary for ongoing business operations