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By inspecting Table 1-1, it's apparent that the Net Income (NI) can be expressed as

[1-1]Net Income = Revenue − Cost of Goods Sold − Operating Expenses

− Depreciation & Amortization + Interest Income

− Interest Expense − Taxes Paid4

or

[1-2]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid

where:

± NetInt is a short form way of expressing “+ Interest Income – Interest Expense”

Table 1-1 Basic Income Statement

While Equation [1-2] is a solid definition of Net Income, it is often more useful to break it into its various constituents such as Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA), Earnings before Interest and Taxes (EBIT), Earnings before Taxes (EBT), and Net Income (NI).

The EBITDA, EBIT, EBT, and Net Income Relationships

Again referring to Table 1-1, it should be clear that the Gross Margin (GM) can be defined in terms of the Revenues (Rev) and the Cost of Goods Sold (COGS).

Revenues represent the dollar amount the Company has charged its customers for its deliverable. The Cost of Goods Sold is the cost the company incurred producing the deliverable, and Gross Margin is what the Company has left over to cover Operating Expenses, Depreciation, Amortization, Interest, Taxes, and Profit.

[1-3]GM = Rev − COGS

In addition to the cost incurred to produce the deliverable, the Company also incurred costs such as Sales, Marketing, Research and Development, and Administration. These costs are known as Operating Expenses. The difference between the GM and OpExp is called Earnings before Interest, Taxes, and Depreciation and Amortization (EBITDA).

[1-4]EBITDA = GM − OpExp

Depreciation represents a charge to the Income Statement for Property, Plant and Equipment (PP&E) that has been purchased and is being expensed over its useful life. Amortization is similar except that it pertains to Intangible Assets the Company may have purchased such as patents, which, like PP&E, are expensed over their useful life. The difference between EBITDA and Depreciation and Amortization is the Earnings before Interest and Taxes (EBIT).5

[1-5]EBIT = EBITDA − D & A

Then allowing for the impact of Net Interest6 (NetInt) on Earnings before Interest and Taxes provides Earnings before Taxes (EBT).

[1-6]EBT = EBIT ± NetInt

Subtracting Taxes Paid7 (TaxesPaid) from the Earnings before Taxes yields the Company's Net Income (NI).

[1-7]NI = EBT − TaxesPaid

Since Taxes Paid are a function of the Earnings before Tax and the Tax Rate (TR), then

[1-8]TaxesPaid = (EBT)(TR)

Substituting in Equation [1-7],

[1-9]NI = EBT − (EBT)(TR)

Simplifying,

[1-10]NI = (EBT)(1 − TR)

NI can be expressed in terms of EBIT or EBITDA. Substituting the results of Equation [1-6] for EBT in Equation [1-10] gives an expression for NI in terms of EBIT.

[1-11]NI = (EBIT ± NetInt)(1 − TR)

To get an NI expression in terms of EBITDA it is necessary to once again refer to Table 1-1 and Equation [1-5] and then substitute for EBIT in Equation [1-11].

[1-5]EBIT = EBITDA − D & A

[1-12]NI = (EBITDA – D & A ± NetInt)(1 − TR)

Equation [1-12] says that for any given EBITDA, a company's Net Income is a function of the Depreciation and Amortization associated with investments made in prior periods, any interest paid or received and taxes.

This is not a book about taxes. So, other than going on record stating that management should employ the best professionals they can afford to help them minimize taxes there will be little more said on the subject.

Interest is of course a consequence of cash on hand or debt, which is a component of the company's capital structure (how the business is financed by the owners). Debt and its implications will be revisited when leverage is discussed in Chapter 9.

Depreciation and Amortization, as stated earlier, is a period expense that results from depreciating or amortizing assets over their useful life. Once money is spent on an investment, the investment is capitalized on the company's balance sheet and then written off by periodic charges to the D&A account on the Balance Sheet via the Income Statement over the asset's useful life. Successful management teams consistently make investments that provide a recurring contribution to income greater than the associated periodic D & A.8

Special Case: Ignoring the Interest Component

While debt and associated costs must be thoughtfully managed, when it comes to creating value, management's prime responsibility is to focus on what happens to the money invested in the business. In fact well-managed private and public companies don't want their management teams spending a lot of time on financial engineering. As far as management is concerned capital structure need only be addressed periodically when the company needs funds to finance such things as a major acquisition. Investors want their team to concentrate on creating value, which is done by growing the top and bottom lines of the Income Statement. When it's appropriate to ignore the “Interest” component, then Equations [1-11] and [1-12] become Equations [1-13] and [1-14] respectively.9

[1-13]NI = (EBIT)(1 − TR)

[1-14]NI = (EBITDA − D & A)(1 − TR)

Example 1-1: Calculating Net Income

Using the data in Table 1-1 and Equations [1-2], [1-11], and [1-12] show that the Net Income in each case is $6,900,000.

Applying Equation [1-2] and substituting values for each of the terms from Table 1-1 gives an NI of $6,900,000 as expected.

[1-2]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid

NI = 100,000,000 – 40,000,000 – 43,500,000 – 5,000,000 – 4,600,000

= $6,900,000

Similarly, applying Equation [1-11] gives the same result.

[1-11]NI = (EBIT ± NetInt)(1 – TR)

NI = (11,500,000 – 0)(1 – 0.40) = (11,500,000)(0.60) = $6,900,000

Finally, substituting in Equation [1-12] shows that all three equations yield the same amount for the Net Income.

[1-12]NI = (EBITDA – D & A ± NetInt)(1 – TR)

NI = (16,500,000 – 5,000,000 – 0)(1 – 0.40) = (11,500,000)(0.60) = $6,900,000

Why EBITDA?

The reader may have noticed that after analyzing the Income Statement in terms of various definitional equations the discussion seems to have settled on a couple of equations built around EBITDA. As will be seen later, it turns out that EBITDA is often an excellent proxy for a company's ability to generate cash flow.

There are only two business reasons to own or invest in a company. One is that the company will grow its earnings and therefore value. The other is to receive dividends from the cash flow. In practice, it is often a combination of both. In order to generate cash a company must be profitable and have Net Income.10

Furthermore, because of the correlation between EBITDA and Cash Flow, EBITDA can be used as a proxy for Cash Flow and therefore it is useful in valuing a business. The valuation of companies is the subject of Chapter 4. However, since Chapter 4 is several chapters away, the role that EBITDA plays in valuation is illustrated by Example 1-2. Before moving on to the example it's necessary to say a few words about something called an industry multiple.

Industry Multiple

Briefly, an industry multiple is an indication of the value investors assign to the industrial sector a particular company serves and the company's ability to create EBITDA and future cash flows. These multiples can vary over a wide range from near “1+” to “20+.” For the purpose of this example the industry multiple is assumed to be nine (9).

Example 1-2: Using EBITDA to Value a Company

Companies can be valued in a number of ways, including the present value of cash flows and/or an appropriate industry multiple. When the applicable multiple is known, the value calculation is straightforward. There are instances where the multiple isn't readily available, nor for that matter are the cash flows. In instances such as this, an estimate of an industry multiple can be made by making use of historical and forecasted financial statements and using the Revenue and EBITDA growth rates to estimate a suitable multiple.

(a) Valuing a Company Using the Industry Multiple

In its simplest form a company can be valued by using the following relationship:

[1-15]Value = (EBITDA)(Industry Multiple) – Debt + Excess Cash

In the interest of simplicity it is assumed that the cash shown on the balance sheet in the following and other examples is necessary for the day-to-day operations of the company and therefore the excess cash is zero and Equation [1-15] becomes Equation [1-16].

[1-16]Value = (EBITDA)(Industry Multiple) – Debt

The company represented by the Income Statement (Table 1-1) has an EBITDA of $16,500,000. According to the Balance Sheet (Table 1-3) the company doesn't have any Debt. Since the industry multiple is 9, an indication of the company's value is obtained by substituting in Equation [1-16].

Value = (16,500,000)(9) – 0 = $148,500,000

If the company had $10,000,000 of debt, then the value would be

Value = (16,500,000)(9) – 10,000,000 = 148,500,000 – 10,000,000 = $138,500,000

Why is debt subtracted? Consider the following. Assume someone purchased the company for $148,500,000 and rather than zero debt, it had $30,000,000 of debt. The buyer would be assuming responsibility for the $30,000,000 obligation. Since this debt ultimately has to be paid off, the total cost to the buyer would be $178,500,000. Now, one may note that the company has cash and it's reasonable to ask who gets the cash when a company is sold. The answer is, it all depends. Typically if the cash is necessary to fund the day-to-day operations (Working Capital), then it stays with the company. If there is excess cash, the seller normally keeps the excess.

(b) Valuing the Company If the Industry Multiple Isn't Known

The valuation in Part (a) of this example is only an indication of value. The correct way to value a business is to calculate the present value (PV) of future cash flows. However, since present value techniques are the subject of a future chapter, this method is not available at this time. So absent a PV valuation, other indications of value are the Revenue and EBITDA growth rates. The historical and projected Revenue and the EBITDAs for the Company with the Income Statement presented in Table 1-1 are shown in Table 1-2.

Table 1-2 Valuing a Company If the Industry Multiple Is Unknown

Assuming the forecast for Year n is accurate and using the data in Table 1-2, the Historical Compound Annual Growth Rate of Revenue, CAGR_HR, is calculated with the assistance of Equation [1-17]:11

[1-17]

Substituting in Equation [1-17]

%CAGRHR = 7.2%

Similarly, the Forecasted Compound Annual Growth Rate of Revenue (CAGRFR) is calculated by using Equation [1-18].

[1-18]

Substituting in Equation [1-18]

%CAGRFR = 9.1%

Assuming the historical growth rate has been a steady 7.2 % and the projected Revenue growth rate of 9.1 % is credible, these growth rates can be helpful in estimating the Company's value to the extent they are reasonable proxies for an industry multiple. The historical growth rate is a fact. The question is: Is the projected growth rate believable? If it is forecasted to come about as a result of increased investment year by year in Sales and Marketing, Research and Development, Plant and Equipment, and Administration during the forecast period (implying that management intends to spur growth by investment) rather than grow Operating Expenses at a slower rate to increase the bottom line, then a growth rate of 9.1 % is realistic. On the other hand, it does represent a healthy increase and a prudent buyer would take this into account. Be that as it may, given the information at hand, the only conclusion that can be reached by applying this methodology is to assume the growth rates are indicative of a suitable multiple and that the multiple range in this case can be said to be a range of 7 to 9.

The average EBITDA for the period n – 2 to n is

And for the period n to n + 3, EBITDA is

Recalling Equation [1-16],

[1-16]Value = (EBITDA)(Industry Multiple) – Debt

The company doesn't have any debt or excess cash, hence the implied value is

Value = (EBITDA)(7 to 9) – 0 = (EBITDA)(7 to 9)

The EBITDA to use can get a little complicated depending on the buyer and what they are comfortable with. One way of coming up with an EBITDA is to assume the average of the Historical and Forecasted EBITDAs. Since the EBITDA proposed is the average of the two averages, one might be tempted to use an average of the multiple range (8). However, this company is very profitable and has demonstrated it can grow, and grow consistently, hence there is a strong argument for using the high end of the range. Hence:

or approximately $148 million using these assumptions.

However, as can be seen, the averaging method previously chosen yields an average EBITDA of $16,429,000, which is almost the same as the current year's EBITDA of $16,500,000, so one could argue that a value of $148 million is at the low end of the value range. If the average of the future EBITDAs were used and a multiple of 9 applied, the value would be closer to $168 million.

Value = (EBITDA)(9) = (18,625,000)(9) = $167,625,000