The world of acquisitions runs on 2 items: EBITDA and Multiples.
EBITDA as Charlie Munger calls it (BS Earnings) stands true, it is not cash-flow it's a proxy to it, essentially it's how much a business makes before taking into account major expenses, the reason is for comparables, it makes it easier as EBITDA does not take into account the financial structure of a business.
So, should I make an offer based on an EBITDA Multiple? No!
The reason is that it leads to an overvaluation, which leads to overpaying, which leads to overleveraging cash-flows which put the business and its employees at risk.
Let me explain everything after the "E".
- Interest = Is an expense, it is due to debt associated with the business.
- Taxes = Every business has to pay their taxes, this is not cash-flow.
- Depreciation = This leads to overpaying for depreciated assets, there is a reason for depreciation, it's to account for the loss of value of an asset due to its use/aging.
- Amortization - The biggest number manipulation out there, example: A business can do 1 Million in earnings and be 1 Million Negative, how so? Well, say they purchased a piece of equipment for 1M and depreciated over 10 years, now they can report the difference as earnings when in fact it's just number manipulation and has to be accounted for.
It goes beyond that, such as CAPEX: These are investments the company has made and expects a return in the future, but until then I cannot give you compensation for it. It's an expense.
Now the biggest issue with expenses is you have to identify one-time expenses and recurring expenses. As you would subtract recurring and add back one-time expenses.
So what metric do you suggest?
Well, financial analysts use something called: NOPAT = Net Operating Profit after Taxes.
This is the baseline. Your foundation to base your analysis on, not some pre-expense "cash-flow" and end up realizing that wasn't free-cash-flow.
I go a step further and use NOPAT-C which is Net Operating Profits after Taxes - CAPEX Investments.
And this is what I use for SME's, larger businesses you have to take into account other items.
Now, instead of taking "Rule of Thumbs" and "easy" valuation metrics, to make an offer do the work and take into account what is cash-flow left after expenses and what is cash-flow that is used to cover expenses.
You don't want to acquire a business and use all its cash-flows to service debt, this will leave you without room to grow unless you want to give up a large chunk of equity in exchange for cash, but at the end of the day, a business that's not cash-flowing will always be at risk.
To summarize: The value of a business is its cash-flows / risk.