Adjusted EBITDA …Confused Yet?
Figuring out the income approach to valuation.
By Scott Wright, director of mergers and acquisitions
The most common approach used in valuing real estate brokerage firms is called the income approach. This approach establishes value by methods that capitalize future anticipated benefits by a rate that reflects market rate of return expectations or conditions, as well as the risk of the relative investment. This is typically accomplished by capitalizing a normalized level of historical earnings (almost always the last 12 months). In simple terms, this approach utilizes a multiple of earnings.
When I run into brokers, I never get away without hearing the million-dollar question, “What are the multiples looking like these days?” Multiples naturally ebb and flow with what’s going on in the market. Of course, there are numerous other factors REAL Trends considers when applying multiples as part of our valuations. The focus of this piece though is not multiples, but rather the other important component of the income approach—earnings.
The Income Approach—Earnings
If earnings were as simple as net income on a corporate financial statement, then we wouldn’t be having this discussion. In the valuation world though, the term earnings actually means Adjusted EBITDA. EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization, is a non-GAAP measure commonly used to assess financial performance.
As indicated by its name, EBITDA takes the cost of debt out of play (interest). It also evaluates performance without factoring in the tax environment via federal and state tax add-backs as well as standard tax deduction expenses (depreciation and amortization).
Establishing EBITDA is only half the battle. You then need to make the appropriate adjustments to get that final Adjusted EBITDA number. Why do we make adjustments to EBITDA? We do so in order to project profitability more accurately. When doing valuations, it’s important to put yourself in the shoes of a potential buyer. If I buy this company, what kind of profits can I expect? From a seller’s perspective, you can ask a similar question. If my company were under different ownership, what’s the true picture of profitability?
Adjustments can affect EBITDA in both directions, and below are some of the more common adjustments we see with real estate firms.
- Comparable Cost of Management. If an owner is properly compensated for his or her duties, then there won’t be a huge net effect here. But, sometimes we see an owner who either doesn’t take a salary or underpays himself. If the owner departs, or upon an acquisition is working for somebody else, then we need to adjust for a fair-market salary for his role.
- Non-Recurring Income. Sometimes there are certain incomes that run through an income statement that are non-recurring. Examples would be income from a legal settlement, income from a sub-lease at an owned building that wouldn’t transfer under new ownership and discontinued transaction fee income.
- Rent Normalization. If a broker opened a new office within the last 12 months, the full cost to operate that office won’t be reflected in the income statement. Thus, an adjustment would be made to reflect the full expense of running that office.
- Salary Normalization. This is the same as rent normalization. If new employee positions were created within the last 12 months, an adjustment would be made to reflect the cost of that employee(s) over a full year.
- Owners’ Compensation. Sometimes owners compensate themselves well above fair-market rates. In this case, we would add back anything above what we deem as Comparable Cost of Management.
- Owners’ Benefits. Many brokerages are small businesses owned by either one person or a small number of people. It is their right to run what we’ll call discretionary expenses through their company. Believe me, we’ve seen it all. Any expense we determine wouldn’t be paid for under new ownership, we add back.
- Non-Recurring/One-Time Expenses. We’ll add back any expense over the last 12 months that is truly non-recurring or one-time. Examples would be the cost of developing a new website, the cost of remodeling or refurbishing an office (those expenses that are not capitalized) and extraordinary legal expenses.
- Rent/Salary Normalization. Using the same logic as above, if an office closes or an employee position is eliminated over the last 12 months, we’ll make the proper adjustments to reflect the savings from such occurrences.
When we’ve made all the appropriate adjustments, the product is called Adjusted EBITDA. When using the income approach for valuation, it is this number to which we apply our multiple. If the Adjusted EBITDA is $1 million and our multiple is 3.5, then the Fair Market Value of the firm is $3.5 million.
We’ll make sure to ask all the right questions when we perform a valuation, but if you own a brokerage firm, it will behoove you to keep well-documented records and appropriately track any income or expense that may need to be adjusted.