Talking about profits. The abbreviations above are all well known calculation methods for profits. Or cash flow depending on what you are looking for. I refer back to Pablo’s theorem (Pablo being an academician from Spain who knows 100 ways to value a company – but probably never bought one) of the difference between the two: “net profit is an opinion, cash flow is a fact”. This is to say that net profit is a number generally tainted with accounting principles, and subject to debate, while cash flow either goes into your pocket or it doesn’t. Semantics. In this case the opinion is just as useful as the fact unless of course any numbers are substantially misrepresented.
In any event a lot of people seem to be interested in the definitions which suggests to me that they are not clear. So I will try to clear them up.
Operating Profit – Where We Start
Operating Profit is where we start. Operating Profit is what we use to derive all the other profits. Operating profit refers to everything having to do with the operations. Not interest, not taxes, not other non-operating expenses or revenues. If the company happens to own a yacht and rents it out for extra income, this does not get included in operating profit. Operating profit does include depreciation on operating assets.
In most cases operating profit is the same as Net Operating Profit (or NOI or NOP) which is the raw unadjusted profit from the operation before non-operating items and taxes are taken into account.
Then let us next come down to the “bottom line” or Net Profit After Tax” (NPAT). NPAT takes NOI and adds and subtracts everything else going on in the company whether operating or not. The final number is how much the company earns after taxes and everything else is accounted for.
EBITDA and EBIT – Used For Leveraged Buyouts
Up until now we have numbers that matter to the owners, investors and banks. From here we divert our attention to the numbers that matter to the business buyer. This would be EBITDA, EBIT, SDCF and Adjusted EBITDA. EBIT, or Earnings before Interest and Taxes, tends to get drowned out by EBITDA which is much more widely used in the marketplace. So let’s set that one aside for the moment since it can be very close in calculation to EBITDA and even NOI. EBITDA is a raw profit number before subtracting out Depreciation & Amortization (all non-cash), taxes and interest.
The rationale behind this is that after an acquisition all those numbers will be removed and a clean slate will exist which the new buyer will control. These numbers will be different because Newco will have brand new interest payments, tax structure and depreciation schedules. In many cases Newco might pay little or no taxes because the buyout will incur substantial expenses, mainly interest.
Adjusted EBITDA, the final calculation from which we do our valuation, goes one step further and adds back any expense items that would not be present after the buyer closes on the deal. This generally includes bonuses, salaries to the extent they are above market and any other owner perks. Thus in the schedule below we can take our adjusted EBITDA and use it to calculate a price. Such as $160,000 x 4 = $640,000. This will depend on the multiple to be used, but you get the idea.
SDE, SDCF, DCF – Used for Smaller Retail Companies
Finally, There is SDE or SDCF or DCF(Seller Disctionary Earnings, discretionary cash flow) which admittedly are not all the same but all refer to the same concept. While EBITDA calculations assume there is a manager taking a full market salary, and deducts it from the profit, the DCF numbers do not. These numbers are used for smaller deals, mom and pops, retail stores etc. The numbers add back all of the owner’s salary and perks, not just the excess over market. This makes a big difference in the calculation and the price.
As a result the multiples of companies with represented DCF numbers are going to be smaller than EBITDA multiples. Such as 2x-3x instead of 3x-4x. The valuations should be similar for the same company but the multiples are always different depending on how the deal is presented to you. I try never to make offers on companies that need a DCF calulation because they are generally too small. Moreover, the calculation presumes the owner will continue to work inside the company – which we don’t want to do. Small DCF calculated companies would often have an EBITDA of near zero if you tried to subtract out a salary for a manager.