The formulas, tricks and trade secrets of Private Equity

Private Equity Valuation

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This post follows on from these previous posts:

  • What’s the deal with capex anyway?
  • Free cash… flow, a primer
  • The free cash flow capex conundrum

In all of my posts about FCF, I haven’t yet mentioned why investment bankers and private equiteers don’t use FCF in private equity valuation practice. Well, FCF is still too “bottom line” for business valuation. It includes taxes and, depending on what version you use (there’s FCF, FCFE & FCFF), it can still be swayed by capital structure. This is why good ol’ EBITDA still forms the basis of most valuations.

However, EBITDA isn’t the perfect measure for private equity valuation either; it is still an accounting construct. The advantage of EBITDA over FCF/FCFE/FCFF is that it is independent of depreciation, cost of capital (such as interest on debt) and taxes. The disadvantage of EBITDA is that it doesn’t account for capex, which is a vital driver to ongoing earnings. The other difference compared to FCF, is that EBITDA still includes accrued debtors and creditors. However, for the purpose of business valuation, this is a better representation of the future (as long as there’s no fraudulent manipulation) because accrual accounting is forward looking.

The implication of the capex omission (from EBITDA in a private equity valuation) is that the EBITDA of one business doesn’t compare well to the EBITDA of another business; the reason being that each may have different capex profiles. In a previous post, I explained that we can’t just use historical capex to adjust FCF (or in this case EBITDA), because it usually contains one-off items. So, what many people do is use EBIT as their earnings proxy and for private equity valuations because it accounts for capex via depreciation (the argument being that depreciation is a good proxy for capex). Of course, this is fraught with danger because the past isn’t the future and the future isn’t the past. If anything, most businesses will spend more on capex than they depreciate as they grow and enter different industries.

Unfortunately, the solution isn’t so simple. In my opinion, the best earnings measure to use for business valuation is a maintainable and forward-looking EBITDA figure adjusted for the capex required to operate the business under normal conditions. Most of the work will probably go into understanding the real capex position of the business, but at least you can sleep well knowing you’ve invested on robust, rigorous and realistic analysis. So just to recap, the potential measure for earnings when calculating value includes:

  • NPAT - almost never used, too “bottom line” and a pure accounting construct
  • FCF - still too “bottom line”, capex is often backward looking, rarely used in valuation
  • EBITDA - ignores capex, which is an absolute sin, but this measure is commonly used
  • EBIT - ignores the evolving nature of capex, sometimes used, 2nd best of many bad options
  • EBIT-DAC - can still be manipulated by accruals, but the best of a bad lot

For the record, in Europe, EBITDA minus capex is denoted as EBIT-DAC or EBITDAC.

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