The following is a contributed piece from Brian Garfield, managing director of global advisory firm Lincoln International. Opinions expressed are author's own.
Pandemic-created challenges have led CFOs to evaluate whether they should include incremental adjustments to earnings before interest, taxes, depreciation and amortization (EBITDA), as they attempt to measure their company's earnings power.
EBITDA adjustments have long been accepted by lenders and sponsors as a way to estimate a company's earnings power and reflect how a buyer would evaluate its performance.
Commonly accepted adjustments across the industry — and particularly in compliance certificates agreed to between sponsors and lenders — include one-time expenses like litigation or transaction related costs, and non-cash expenses like impairment charges and stock-based compensation.
An unprecedented event like the pandemic would seem to be a textbook moment for EBITDA adjustments to skyrocket as companies attempt to normalize earnings.
Yet, surprisingly, the magnitude of EBITDA adjustments, never great to begin with, has waned since the start of the pandemic, decreasing from 24.4% of EBITDA in the fourth quarter of 2019 to 21.8% in the comparable quarter last year.
Even more surprising, only 1.6% in adjustments were directly related to the pandemic, as indicated by an analysis conducted by Lincoln International across a database of more than 1,700 predominately privately held portfolio companies.
It seems unlikely that companies wouldn't factor in adjustments to earnings given the circumstances, which might suggest businesses are taking different approaches to estimating normalized earnings.
As CFOs evaluate the earnings power of their company, one question stands out: should I consider adding back pandemic related losses and costs? Or is the industry accepting different ways of measuring my company's performance?
The answer to the question depends on the company itself and the context of the industry in which it operates.
For businesses that experienced demand destruction during the pandemic, it would be difficult to argue that it would return to historical levels and adjust EBITDA on this basis.
However, for those that experienced demand disruption, a very strong argument could be made that the business will eventually return to pre-COVID levels and therefore incorporating an adjustment would be deemed acceptable.
When assessing the appropriate value driver, buyers and sellers are striking a balance between prioritizing historical performance while at the same time being open to looking at additional metrics.
However, in cases where companies were heavily disrupted, CFOs can convincingly argue that last twelve month (LTM) EBITDA during the pandemic is an incorrect valuation driver, since it wouldn't capture the true earnings power of a company. Instead, other measures of earnings power should be considered.
Determining the value driver
The events of 2020 could not have been predicted and were beyond expectation. The market recognizes that earnings need to be normalized, but to what degree remains a great debate. Sellers will not sell at trough earnings, but buyers need assurances that the lower earnings levels are not the new norm. As a result, three strategies have gained popularity in measuring earnings power during this time.
1. Annualizing earnings
For some, business during the fourth quarter of 2020 returned to more normal conditions compared to when COVID was at its height. For businesses disrupted in the spring, annualized earnings, either in the form of a last quarter annualized (LQA) approach or by annualizing post June performance, might be a more accurate measure of business performance than metrics from 2020.
2. 2021 EBITDA
To the extent CFOs are more comfortable assessing 2021 EBITDA, given the better visibility they have into the full year's budget—including contracted revenues and full implementation of cost-cutting measures—they might prefer to focus on 2021 performance and underweight 2020 results.
3. The swap out
Another twist to LTM EBITDA is to replace the months most impacted by COVID-19 with the earnings results of those same months from 2019. Swapping out those months with 2019 performance is an easy way to reflect actual levels that were once earned.
No matter which path is taken, selecting a defendable metric is critical. Evaluate KPIs to ensure the normalized metric is one that market participants would actually rely on.
One strategy is to pressure-check your approach, just as a valuations team would do during a due diligence discussion.
Ask yourself: If you are accounting for cost savings made during 2020, are these temporary or truly permanent cost reductions? Are incremental costs required to generate growth? And have you achieved these earnings levels before?
Ultimately, when considering any normalization or adjustment to earnings, be careful that you're not overstating EBITDA and that you can provide a clear rationale to solidify your position. Buyers and sellers will certainly ask questions.