EBITDA and intangibles: Improving financial statements

EBITDA and intangibles: Improving financial statements

Author: Joris Kersten MSc

Kersten Corporate Finance: M&A Advisory Netherlands. www.kerstencf.nl

Training: Business Valuation & Deal Structuring, 5 days, Amsterdam, 4th – 8th November 2024. www.joriskersten.nl

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights, Intangibles and earnings: Improving the usefulness of financial statements. April 2022. Michael J. Mauboussin and Dan Callahan.

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Introduction

In recent decades the ability to interpret financial statements has been complicated by the shift from tangible to intangible investments.

Tangibles investments are for example factories or trucks.

And intangible investments are non physical and include for example brand building or employee training.

Accountants primarily reflect intangible investments in the income statement.

And intangible investments are only recorded on the balance sheet, and amortised in the income statement, following an acquisition.

A sensible solution to this challenge would be to capitalise investments from the income statement.

And to amortise them over their useful lives.

But the question is what items from the income statement need to be capitalised?

And what is the useful live of these investments?

Overall it is estimated that capitalising these investments right, would raise earnings of the S&P 500 for about 12%. As a source, please consult the source I have used for this blog.

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Accounting and valuation

Valuation techniques that are often used are P/E ratios (price vs. earnings) and EV/ EBITDA multiples (enterprise value over EBITDA).

When intangible investments are taken up in the SG&A expenses, instead of in CAPEX, this does not affect free cash flow.

Free cash flow is the yearly full cash out, so whether you have investments in the expenses, or in the CAPEX, free cash flow = free cash flow.

So with discounted cash flow valuation (DCF) there is no problem.

Only be careful with your terminal value, so keep using the “gordon growth” formula, and NO EBITDA exit multiple.

And then you are just fine.

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Multiples on earnings

With multiples on earnings, this could potentially be dangerous.

Multiples, like EV/ EBITDA, are heavily used all over the globe.

When intangible investments are in the expenses, and not in CAPEX, your EBITDA is too low.

And this results in an artificial high EV/ EBITDA multiple.

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The impact of intangibles on earnings

In order to clean the EBITDAs and profits correctly, we need to judge for every target what percentage of SG&A is an investment.

And what the appropriate asset life is.

By the way, for all the “comparable companies” and “precedent deals”, for EV/ EBITDA multiples, technically you should do the same.

To be honest, I am not there yet, but I find this topic very interesting, so will write a lot more on this! (when time permits)

Concerning SG&A, it should be separated in two parts:

-Main SG&A = SG&A -/- R&D;

-R&D.

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Research

Most researchers have historically seen all of R&D expenses as intangible investments.

Again, please see the article I have used as a source for this blog, for the research meant here.

Their analysis also finds that between 0 and 80% of “main SG&A” is an investment across the range of industries.

With an average of 54%.

And they estimate that a range of 7% to 98% of R&D expense is an investment.

With an average of 76%.

And concerning the asset life.

Tangible assets have an average life of around 10 years.

Concerning SG&A that is actually an intangible investment, we need an asset life for its amortisation.

The researchers found that useful lives for “Main SG&A investments” would be 0.25 to 5 years.

With an average of 3.3 years.

And they found that the useful lives for R&D investments range from 0.5 to 7 years.

With an average of 4.4 years.

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Growth

Finally, we need to estimate growth in these type of SG&A investments.

Because ONLY when there is growth, it will have differences in the timing between the removed expenses, AND the added depreciation.

So growth opens the gap between the current investment expensed, and the amortization of past investments.

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This was it for now, I hope this blog was helpful.

For me this is a very interesting topic, and a new and better way to clean EBITDA. And the EBITDAs of “comparable companies” and “precedent deals”.

It definitely caught my attention, and I will write a lot more this (when time permits).

See you next week again, with a new blog, best regards Joris????

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Source used: Morgan Stanley Investment Management, Counterpoint Global Insights, Intangibles and earnings: Improving the usefulness of financial statements. April 2022. Michael J. Mauboussin and Dan Callahan.