Some small companies like liquor stores are purchased using a rule of thumb such as, “1x revenue plus inventory”.  However larger companies, especially those using EBITDA for the valuation metric, are valued with inventory included (an average, historical level sufficient to generate the advertised EBITDA).  It is frustrating for many business owners, because they know they bought that inventory with their own money, and they want that money back!

Unfortunately it doesn’t work that way.  In looking at this, it is helpful to look at it from a buyer’s point of view.  Put yourself in their shoes and look at the following scenarios.  There are three companies, each one generating $1mm in EBITDA.

Company 1:  $1mm in uncommitted inventory.

Company 2: A software company with no physical inventory.

Company 3: $1mm in presold, commited inventory.

Let’s assume 5x EBITDA is good starting point.  For example, Company 2 is worth $5mm.  But what are company 1 and 3 worth?

Let’s assume you plan on keeping the company for 7 years and then selling it.  So you pay $5mm, then you get $1mm per year and finally you sell it for $5mm (WAY over simplified, but you get the picture).  You would earn 19% return on your invested equity doing that.

Now let’s say you buy company 1 and pay 5x EBITDA PLUS the inventory.  So you pay $6mm, get $1mm per year and finally sell it for $6mm (assuming you can convince someone else to pay for the inventory).  If you did this you earn 15% on your invested equity.  Not nearly as good because you had an additional $1mm tied up in the company.

So, if you paid for inventory on top of the base 5x value, this is what the three companies would do for you as a buyer:

If you are a buyer, you would probably buy Company 2.  It has 19% return and costs $1mm less.  Some would say, “Yes, but the other companies come with a real tangible asset, inventory”.  Some would even say, “And you can shut the company down and get the inventory back!”.  Well, yes, but then you wouldn’t get the $5mm back for the purchase price so the ROI would be even less.  In addition, usually the salvage value of inventory is only a fraction of the value (Company 1).  There is some small amount of comfort that if everyone goes bad you have some inventory, but it is typically not something the buyer is planning for.

Inventory (and plant and equipment) does make financing easier, and financing can leverage your equity and boost the returns.  So it can raise the value, but not much.

When businesses are valued using EBITDA the business is delivered, “with gas in the car”, which means there is an adequate level of working capital to run the business – and this includes inventory.  Now, it doesn’t necessarily include ALL inventory, but is a topic for another blog entry.