Gauge Quality of Earnings When Buying a Business

One of the most important factors in valuing a business is the quality of earnings, or QoE. In other words, are the company’s earnings sustainable and predictable over a period of time, and are past earnings a reasonable representation of future earnings?

QoE impacts a company’s ability to generate cash flow to pay off debt, invest in future growth, and generate a positive return on investment for its owners. It is critical to gauge QoE when buying or selling a business to prevent overpaying for a future earnings stream that fails to materialize.

QoE Risk Factors

There is a long list of QoE risk factors to consider when valuing a business you are thinking about buying, including the following:

• High customer concentration

• Limited access to capital

• Expiring customer contracts (or no customer contracts)

• Industry volatility

• Technology obsolescence

• Lack of pricing leverage

• Low barriers to entry for competitors

• Over-reliance on owner’s personal relationships with customers and suppliers

• Lack of product or service diversification

• Workforce instability and labor availability

• Susceptibility to changes in government or industry regulations

• Vulnerability to geopolitical instability

These risks could lead to a business not generating future earnings that are in line with past earnings, and therefore not commanding a high selling price.

Metrics Buyers Consider

Two key metrics buyers consider when evaluating a business for purchase are earnings before interest, taxes, depreciation and amortization (EBITDA) and seller’s discretionary earnings (SDE).

EBITDA is perhaps the most commonly used metric when valuing a business because it provides the most accurate picture of operating performance by excluding non-operating expenses. Add net income to interest, taxes, depreciation and amortization to calculate EBITDA. The higher the EBITDA, the more valuable the business.

By excluding non-cash expenses, EBITDA also provides an accurate picture of a company’s cash flow, which is critical to a company’s ability to generate cash to service debt and generate return on investment. However, EBITDA does not account for changes in working capital or differences in capital structure, which can affect profitability.

SDE considers the owner’s compensation, perks, non-cash expenses (such as depreciation) and other non-essential business expenses in valuing a company. It is typically used to value small, owner-operated businesses with owner-related expenses that are not essential to business operations, such as the owner’s salary, health insurance, and other perks. Adding these to the equation provides a more realistic view of profitability.

To calculate SDE, EBITDA is added to the owner’s salary, perks, and other discretionary expenses noted above. In other words, SDE represents the cash flow a business generates before paying the owner. The higher the SDE, the more valuable the business.

QoE and Business Valuation

A company with high-quality earnings has a sustainable income stream that is not overly reliant on one-time events or non-recurring revenue streams, along with strong profit margins and consistent cash flow. This justifies a higher valuation and purchase price due to less risk of the income and profits not materializing in the future.

Conversely, a company with low-quality earnings may have a less-reliable income stream that is subject to market fluctuations, technology innovations, or higher customer concentration. All else being equal, this results in a lower valuation and purchase price, due to the higher risk of income and profits not materializing.

Do not Overpay for Earnings

Your business valuation team will consider these and other quality of earnings risk factors when valuing any business you are considering acquiring. This will help you avoid paying too much for the business from an earnings standpoint.