The term fell again regularly in recent weeks during negotiations: the payback period. The moment I hear that, I always sit a little straighter in my chair....
From the buyer's point of view, I understand the question. They want to know how quickly the investment will pay for itself. What is the value and the payback period? Well, there is a very simple calculation method for that:
The cumulative future cash flows in the above example after five years are exactly equal to the acquisition price (5 x 800 = 4,000). So if cash flows develop as forecast (an important assumption), the acquisition is certainly not loss-making after five years. From year six, all positive cash flows are profits. Simple right?
Losing money, or not?
Why am I always alert when the payback period card is played? Probably because of the, to me, negative connotation. Buyers (and sometimes their advisers) like to use it when they think the acquisition price is too high. 'I come to a payback period of six years. Then I'm working six years for nothing,' I hear. Or, 'By definition, I think an investment should be recouped in five years.'
Company retains value
At those moments, I drop out. The first case completely ignores the fact that a company retains a value. In the simple example, the business is still worth 4,000 after five years.
The buyer has paid 4,000 at that point, had 5 x 800 in incoming cash flows, and then still has a business worth 4,000 in his hands. Count your winnings. The kite goes even if the purchase price is borrowed from a bank. The return in the example averages 20% and the investment is paying off from the start.
Waarde and payback period
In the second case, it is stated that the payback period "by definition" should not exceed five years. What law is that based on?
It probably originates from the banking world in which (mostly largely blank-covered) acquisition financing must be repaid in a period of five years. That comparison fails as far as I am concerned: a bank is not an investor-entrepreneur and does not operate as such.
Moreover: the latest multiple analysis by Brookz shows that the average acquisition sum in SMEs is around 5x EBITDA(Earnings Before Interest, Taxes, Depreciation and Amortization). Cash flow is always lower than EBITDA. After all, (replacement) investments (in fixed assets and net working capital) and taxes still have to be subtracted from this.
So an acquisition price of 5x EBITDA never actually has a payback period of five years.
Negative connotation
But maybe I also just have trouble with the word itself. It implies that a lot of money is lost first that has to be made up. That creates that negative connotation.
So is the term nonsense? No, that's too short of the mark. It will be able to help a buyer as a prefix. Especially when it comes to the purchase of assets (for example, machinery), contracts with a limited duration or a company with an uncertain existence. At that point it is good to know where the tipping point of cumulative profit lies in relation to the limited life of the object of purchase.
But for the acquisition of an entire company, this consideration should play much less of a role.
Return on Investment (ROI)
We therefore prefer to calculate and analyze in terms of return on investment (ROI) in relation to the estimated risk profile of the investment. Possibly in combination with scenario analyses.
That does justice to the in itself valid thoughts behind the payback period, but without the negative side effects. Combined with ROI and scenario analysis, it works better methodically and is also simple AND understandable for buyer and seller.
