This is CFO Secrets. The weekly newsletter that serves up oven ready CFO insights.

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In Today’s Email:

• 🧪 How to review Quality of Earnings

• 🤓 Inspiration from Bill Gates

• 💵 Cashflow Tip of the Week

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THE DEEP DIVE

Quality of Earnings: The Four Levels of EBITDA Adjustments.

This is week 5 in an 8 week season covering the world of M&A from the seat of the CFO

We’d made a first round offer of $200m.

10 x EBITDA, with a bit of rounding upward.

We were comfortable that 10 was the most we could pay for a well established market leader in a segment of a mature market.

We hadn’t done any DD yet on EBITDA, but we were confident it would lie at $20m +/- $2m.

It had been in that range for most of the last five years. And EBITDA for the financial year recently finished was $20.3m.

Should be a straight forward Quality of Earnings (Q of E) work.

I ran the Q of E myself.

The CFO refused to engage a Big 4 Financial Due Diligence (FDD) team.

He wasn’t confident 10x was going to be enough to win the auction so wanted to limit abort costs.

I’d managed to twist his arm into agreeing to second a senior manager from KPMG into my team for a four week stretch.

Better than nothing I guess.

Under-resourced, but should be straight forward.

Not quite.

We started by getting underneath the revenue line. It wasn’t long before we found a problem. The seller had recently reduced prices to customers in exchange for extending contract lengths.

Not an unusual game for a seller to play.

But what was unusual here was the size.

A blended average of 4% price reduction; or $200k per week. Straight to the bottom line.

Let me help you with the quick math.

$200k = $10m per year on a run rate.

That was half the EBITDA.

HALF.

Meaning that our 10x multiple was more like 20x on a run rate.

Forget it.

But that wasn’t the worst of it.

The question was not, what was the impact on EBITDA. The question was why had they had to discount so hard to keep business.

As we looked harder we realized that their top line had been under attack on all fronts.

This was a business at risk of terminal decline, using pricing to buy loyalty.

The very definition of poor quality earnings.

Looking harder at the last year, showed that the Income Statement had been propped up by any means necessary.

Marketing budgets slashed by $5m per year inside 12 months. Accrual releases in the current year. Aggressive capitalization of expenses.

The P&L was a shell. We could fix it, but there was no way we were going to pay the seller for the privilege. Our work, our upsides.

After a drawn out Q of E review, we revised our bid from $200m to $70m.

The seller rejected our offer.

We ended up buying the business two years later for $30m.

Even at $30m I still feel we overpaid.

Even now.

Information Asymmetries in M&A

Understanding the integrity of the underlying earnings in a business is 90% of the work in an M&A deal.

There are massive information asymmetries in M&A.

On one hand you have a seller who knows a lot about their business, including where the bodies are buried. If those bodies affect valuation, they have a direct incentive to keep them hidden.

On the other hand, you have a buyer who only knows what they are told, or what they can find out in a limited time window. They have a direct incentive to discover the ‘bodies.’

Due diligence is a process of leveling those information asymmetries. And in most deals; the Quality of Earnings review is the most important limb of the DD.

Using Discounted Cash Flows.

In my earlier piece on valuation I explained why I don’t care much for DCF as a valuation method.

Or indeed any method that is over reliant on forecasts.

Even forecasting a business you do own over a multi year period is difficult. And rarely results in accuracy.

It is the forecasting process that is useful, not the forecast.

Now overlay the ‘fog of war’ of M&A with a business that you do not own, and do not have the inside track on. It’s nearly impossible to generate meaningful output.

I understand the arguments against this. I’ve heard them all.

An over-reliance on forecasts in M&A is an exercise in false precision. Providing false comfort over something that is not controllable.

The biggest manufacturing plant could burn to the ground on day 1 of the acquisition. Where do you build that into your DCF?

Run Rate Performance

Where you can be very precise is about the current run rate P&L and Cashflow for a business.

That is something you can get scientific about.

Precision that is actually valuable.

And whilst this is still an exercise in judgments, you can improve the quality of those assumptions significantly with intelligence.

The current underlying cashflows of a business are what you are buying.

If you buy a solid cashflow stream, at a price that makes undeniable sense. And then back yourself to move those cashflows in the right direction. You cannot go wrong.

How do you build this intelligence? You go deep on key assumptions, and the current trading patterns. What you learn will help inform the multiple you should pay too.

Are the approaches mutually exclusive?

Remember an M&A process is on a timeline.

Speed of execution is king in M&A.

Time, specifically DD hours, are the most scarce resource in M&A.

Use them well.

Quality of Earnings

So, what is a ‘Quality of Earnings’ review.

I love the name.

It says everything about the process.

It's not just about the size of the earnings, it's about the quality of them. The longevity. The potential to grow. The resilience against decay.

Quality of Earnings reviews should be conducted across the whole financial statements.

But focus is on our old friend EBITDA.

The backbone of our valuation methodology is an EBITDA assumption. We will apply a multiple to it.

If that multiple is 10x for example, every $1 of EBITDA is worth $10 of value. There is a lot at stake here.

The Q of E review will help us get that EBITDA assumption right.

Note: We do need to talk about capex, but we’ll come back to that later

First, we are going to go on a journey of adjusting EBITDA.

“But Secret, I thought we shouldn’t adjust EBITDA?”

This point is misunderstood.

Imagine if we hadn’t have made the adjustments to EBITDA in the earlier example?

We would have justified overpaying by more than a factor of 2.

There are lots of fun memes around Adjusted EBITDA.

I’ve made plenty of them myself. But the joke here is how companies abuse adjustments to EBITDA to get a convenient answer.

It’s not ‘adjusted EBITDA’ that’s the problem, it’s the adjustments themselves. And they need evaluating one by one

A lot of the takes on EBITDA also cite Charlie Munger for describing it as ‘bull shit earnings.’

He’s right, it’s bullshit as an earnings measure. But we are not using it as an earnings measure here. We will overlay, capital investment, interest and tax separately.

We will come back to how we overlay the effects of capex working capital etc.

And if you use EBITDA, properly adjusted, as an input to a cashflow based calculation, it is golden.

The questions are:

• What are those adjustments?

• Are they credible?

• Are they complete?

• Are they properly valued?

This is where you spend your time.

This is where you focus your Q of E work.

And in doing so, you will learn so much about the business, valuing it will feel much easier by the end of it.

Building a Proforma EBITDA Restatement

Now we will build up EBITDA step by step to a level it can be used it for valuation.

But we need to start with a solid base.

That means a GAAP basis EBITDA built on a recent trailing twelve month (TTM) period.

Put another way. EBITDA as stated for a recent 12 month period. Pulled directly from financial reporting.

Something that ties directly to the underlying books and records.

For a business with a December year end, running an M&A process in May 2023, they may use the TTM EBITDA as at the end of Q1. Total EBITDA from the accounts for the period Apr 22 - Mar 23. I.e. the most recently available credible 12 month period.

That becomes your start point, and becomes the reference for your analysis.

Then we ask a series of questions of that period and adjust it accordingly. And carefully.

To make it more relevant for the business as it stands at May-23.

These adjustments fall into four buckets. They are in order of objectivity.

Starting with the most objective, ending with the most subjective:

1. Adjustments for One-offs

2. Adjustments for Run Rate Effects

3. Proforma Adjustments

4. Adjustments for Initiatives in Progress

Think of Q of E like an ‘FP&A Audit’. Deep FP&A work on business performance, to get the truest statement of the underlying run rate.

Like peeling an onion. With the truth hiding inside.

The last Q of E review I conducted had more than 40 adjustment lines. Each one individually calculated, and considered in the collective.

Let’s jump into each of the four adjustment types in turn.

Level One Adjustments: One-offs

This is a process of normalizing the accounting for any unusual or one-off items. For example, a large severance paid in the 12 month period. If it was a one-off, it would be reasonable to add that cost back.

Likewise in the other direction. If the business ran with a COO vacancy for 9 months. You should deduct the costs of a COO for 9 months to reflect a fully costed EBITDA for the period.

Here are some other examples:

After this, you now have calculated ‘Adjusted TTM EBITDA’.

This could be higher or lower than the pure TTM EBITDA. Another reason why the demonization of Adjusted EBITDA is nonsense.

Level Two Adjustments: Run Rate

Many things would have happened part way through the TTM period (Apr-22 to Mar-23). This means the TTM EBITDA as reported will only capture a part year effect of those impacts. This is where you make the adjustment to capture a full year effect of those impacts.

They gave their staff a 10% pay rise at the start of January? That means the TTM period only includes 3 months of the inflated cost. Here you make the adjustment to reflect the impact of the other 9 months on the TTM EBITDA.

Prices went up in October? Your revenue line only reflects 6 months of that margin improvement. Here you put the other 6 months through.

The higher prices pushed volumes down by 5%? Reflect that too.

The list of possible adjustments here is limitless. And depends on how volatile the business has been in the previous 12 months:

Examine trends on volumes, margins efficiencies, and cost lines carefully to draw out key things that warrant a closer look.

And then you go deep into that particular area until you can quantify the impact. Or until you are satisfied no adjustment is needed.

You have now adjusted the ‘period’ from a Trailing Twelve Months (Apr 22 - Mar 23) to be reflective of the adjusted run rate as at March 23.

Level Three Adjustments: Proforma

This is a slightly more conceptual category.

You have adjusted for one-offs and run rate effects. But you may still have things in the P&L for the period, not reflective of the immediate ‘go forward’ position.

This has been particularly important over the last few years. COVID effects, and the temporary consequences of inflation peaking all being important adjustments.

Here you can also capture any direct effects of a change of ownership. I.e. extra (or reduced) insurance, permits, or back office costs.

Note: these must be considered alongside run rate adjustments (section 2). You will often have adjusted for some or all these effects in other parts of the analysis. Making sure you do not double count any adjustments is very important.

This is a highly judgmental exercise. Often is about aligning the results of the target to your corporate ‘house assumptions’ on socio-political effects:

Once finished here you have Proforma Adjusted Run Rate EBITDA.

Level Four Adjustments: Recent Developments

In section 2, we updated our TTM period to reflect initiatives that reflect the end of period run rate.

Here we look at even more recent developments.

Things that have happened since the cut-off for the TTM review date.

Businesses are not static, they are dynamic and ever changing. Your valuation will need to reflect this (for better or worse).

It’s about being super clear on what you are buying right now.

For example, if the target has a major capex program that completes in April. The seller will likely expect that reflected in the valuation. So, you need to decide whether you agree or not.

These work both ways, of course. Especially if performance has wavered from expectations. Where recent performance is poor, the judgment becomes whether that is temporary or structural. The answer will affect your valuation:

It is not uncommon to give partial credit against recent developments. Based on judgments of the evidence available.

And how repeatable / robust that is.

Validating the Output

Now you have got to the bottom of the EBITDA restatement.

In practice this is a lot of work.

Every single line on the schedule will have analysis behind it. It will be calculated, double checked and scrutinized.

Debated back and forth between buyer and seller. Both have significant stake in getting the answer they want. And this isn’t a ‘win-win’ negotiation. This is straight out of one pocket and into the other.

The output can be triangulated against the target’s budget, and recent management reporting.

For example, imagine the target claims that a new benefit driven by a capex investment will hit from May. And they expect this to be built in the valuation.

This would be a ‘level 4 adjustment’.

As a buyer, you would expect the internal budget for the target to reflect the uplift in performance for that month.

And when the May month is reported, you would expect to see that benefit delivered.

Both a run rate improvement in a metric. And also versus the budget that included that assumption.

This process is all about building evidence and credibility for each adjustment line. There are many ways to do that. And many ways to triangulate.

If there isn’t enough evidence in the dataroom or target to substantiate an adjustment, this is where ‘specialist due diligence’ comes into its own. If it’s a big assumptions, with a wide range, it might be worth spending the money to reduce the uncertainty.

I've found an 'audit' mentally useful here.

There is a reason why the Big 4 fish the best auditors out to join their FDD practice.

Coming Back to Cashflow

Once you have a ‘clean’ position on EBITDA, most people stop there. Apply a multiple and away you go.

I prefer to calculate multiple comparables on an EBITDA minus maintenance capex basis.

If a recurring a working capital movement is needed to maintain EBITDA, this can be reflected too. Although rare.

What is Maintenance Capex?

Judging by replies I get on this topic on Twitter, this is commonly misunderstood.

We are not talking about 'repairs and maintenance' which is an opex line. Maintenance capex is not an accounting issue, it's a finance concept.

Fixed assets decay over time, it’s why we depreciate them. And they need replacing.

The question is what level of annual capital expenditure would be needed to maintain the business. Specifically, to maintain the assumptions underpinning the level of EBITDA.

Typically this can be looked at as a ratio of depreciation. Normally it's 75%-125% of recent average depreciation. The level will depend on how well invested the business is.

Lots of recent investment? A lower ratio will be ok.

Operational sites that are falling to bits? A higher ratio is necessary.

From EBITDA to Simple Free Cash Flow

Restated EBITDA less maintenance capex becomes a sort of simple run rate free cashflow proxy. It is this number you apply the multiple too and compare to the industry.

Multiples

The multiple should be selected from inside a range. The range should based on market comparable transactions (interest rate adjusted).

The more likely Free Cash Flow is to grow higher multiple.

Resilient to risk and reduction? Higher multiple.

More downside risk than upside momentum? Lower multiple.

Quality of Earnings Reviews in Practice

Clearly there is a lot of judgment involved with this process. There are two things that help:

1. Experience in the thought process and methodology of EBITDA adjustments. (Finance Due Diligence Experience)

2. Industry expertise

If you outsource this process to a Big 4 FDD practice, they will give you 1) in spades. If you are lucky you will get a bit of 2, but not much. Even those in Big 4 that claim industry specialism, don’t really have it. Advising into an industry is different to working int it.

Likewise in house finance pros will have 2, but not much of 1 initially (although a blend of FP&A and audit experience helps).

You can build your experience in 1 through practice and reps (and hopefully this post helps a bit too).

But if you can combine these two things as an in house finance pro? Wowee. You will become valuable as an M&A pro.

Couple that with the right external FDD provider you trust and you will have an M&A machine.

Other Q of E Considerations

The Q of E review will also ensure that the information provided ties to underlying books and records. And triangulates with other external and internal reference points. Financial reporting, management reporting, tax filings, etc.

It will also comment on trends in the historical and future forecast performance. This is still valuable, because it all aids understanding of the business. I just prefer to focus my valuation efforts on the current run rate performance of the business.

How you do use forecasts in M&A

I do have some use for forecasts in M&A. As I explained here, I like to use reverse DCF.

Forecasts are important in PE deals, where understanding the exit assumptions is vital.

The forecast methodology I like to use is very simple.

Most forecasts go wrong through a poor understanding of the base. The energy you spent on understanding the current run rate is extremely valuable.

It doesn’t matter what growth rates or trends in KPIs you assume if your start point is wrong.

There is so much more to say on this topic, and I will revisit this in future with fuller worked examples.

I also have a cool analogy I’m working on for explaining the different adjustment methodologies.

I’ll share it when it’s ready.

But that’s Quality of Earnings for now!

Next time we will talk about How to Sell a Business.

THIS WEEK ON TWITTER

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Anyway …

That’s all for this week. As always you can find me here:

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No CFO Secrets next week, but I’ll be back on September 9th with how to sell a business.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.