Since my article last September, entitled How to Sell Your Club for Maximum Value, and October’s What is My Club Worth?, I’ve had a steady stream of questions from readers wanting to know more precisely how the valuation multiple is determined.
• Where does “three to five times EBITDA” come from?
• Why isn’t it higher?
The multiple is handy shorthand for the ratio of the discounted present value of the future cash flow streams relative to the trailing twelve month EBITDA.
In plain English: If the present value of your club’s future cash flows is $2 million, and last year’s normalized sustainable EBITDA was $500,000 then your club’s valuation multiple is 4 times.
EBITDA REVISITED
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” It’s basically a fancy term for the cash flows generated by the club. This is calculated by recasting the income statement to separate operating revenues and expenses from deal-dependent items.
Interest is deal-dependent because a club that is debt-free will have zero interest expense, whereas the same club after being sold may have debt up to the rafters and in turn will have a large amount of interest. The amount of debt doesn’t change the operating cash flows generated by the club business. It’s simply a reflection of the financial structure. Interest is just a “symptom” of that financial structure.
Depreciation is similar. If an owner built his club in 1974, the historical costs were much lower than they would be today, and large parts of the club may be fully depreciated. A similar club built in 1994 would have historical costs that might be double, and these may not be fully depreciated. But lower or higher depreciation expense doesn’t change the actual cash flows that are generated by the business.
“Normalized” means that non-club expenses (like your spouse’s cell phone bills) have been taken out, and you’ve adjusted any other expenses (like your salary) to fair market value. “Sustainable” means that the cash flows can be perpetuated for many years into the future. Depending on your circumstances, your EBITDA to be multiplied may be:
• The average of several years,
• Last year’s figure with an adjustment for the upward trend as your club matures,
• Last year’s figure with a downward adjustment to reflect the impact of a new competitor in the local market.
The multiple shorthand generally counts on around 15 years of future cash flows. If your lease runs out in six years and can’t be renewed on substantially similar terms, then the shorthand doesn’t work.
DISCOUNTING FUTURE CASH FLOWS TO THE PRESENT
“Discounting” means converting future dollars into today’s dollars using a discount rate. The discount rate might be considered reverse interest rate, since it reduces a dollar a year from now to something less than that today. The discount rate you use should reflect the “riskiness” of the club business as compared to other investment options available to investors at the time.
Clubs are generally considered more risky and less liquid than a diversified stock market portfolio, so you might use a 20 percent discount rate to convert future club cash flows to the present.
Remember that projected future year EBITDAs need to be reduced by an allowance for capital reinvestment sufficient to sustain the operating cash flows at the normalized level you’ve determined. The reinvestment allowance may vary by year, depending on what major items you might anticipate.
BOTTOM LINE
If a club in leased premises had five years left on its lease and two five-year renewal options, and if the club’s cash flows were projected to be stable for the foreseeable future, and if you discounted those cash flows using a 20 percent discount rate, you would come up with a present value of about 4 times the starting EBITDA – or a multiple of 4 times. A higher discount rate would result in a lower multiple and vice versa.
DEAL-RELATED SUPPORT
Sellers often find that it pays to have an expert calculate their club’s indicated value. This can then be used as a starting point in a sale price negotiation. Buyers on the other hand, can have a third party review a club’s asking price to make sure it is justified.
A small investment can save a seller from giving away the fruits of many years labor for too little, and it may save a buyer from overpaying.
Peter Kroon is the Founder of FitnessAlliance.com. He can be contacted at 860.829.3589, or by email at pbkroon@fitnessalliance.com, or visit www.fitnessalliance.com.
