Does EBITDA solve or cause your valuation problems?

Does EBITDA solve or cause your valuation problems?

 

When valuing a closely held business, simplicity is often the goal, though not always easily attained.  One of the most common metrics used to estimate a company’s worth is earnings before interest, taxes, depreciation, and amortization (EBITDA). Advisors and business owners often rely on EBITDA as a substitute for operating cash flow and apply a multiple to EBITDA to estimate a business’s value. Its popularity stems from its simplicity of calculation and its perceived neutrality across accounting, financing, and tax differences.

However, while EBITDA can be a useful starting point, relying on it without proper context or analysis can lead to misleading conclusions.

 

Key considerations include: What does the value represent when applying a multiple to EBITDA? How should the appropriate multiple be selected? Which measure of EBITDA is most suitable for the calculation? And What are the method’s inherent strengths and potential pitfalls? This article explores these questions and offers a practical framework for understanding when—and how—EBITDA can be effectively applied in business valuation.

What does the value represent when applying a multiple to EBITDA?

 

Understanding the value represented by EBITDA is crucial when calculating a company's worth. This value assumes the purchase of the company's operating assets and the assumption of trade payables, excluding interest-bearing debt. The primary concern lies in how interest-bearing debt is addressed. The resulting value, known as enterprise value or invested capital, is debt-free. A common error is interpreting this value as equity value. For instance, if a company’s estimated EBITDA is $1 million and the appropriate multiple is 5.0, the resulting value is $5 million. However, if the company has $4 million in interest-bearing debt, the equity value would be $1 million.How should the appropriate multiple be selected?

 

How should the appropriate multiple be selected?

 

Determining the appropriate EBITDA multiple involves analyzing market data from comparable companies and transactions, but finding reliable and truly comparable data can be challenging—especially for private companies where details are limited. Even when data is available, adjustments must be made for differences in size, growth, profitability, and risk. Broader market conditions, like interest rates and buyer demand, also affect multiples. Ultimately, selecting the right multiple requires both careful analysis and informed judgment.

 

Which measure of EBITDA is most suitable for the calculation?

 

Reported EBITDA should rarely be used without normalization adjustments.  These adjustments should be made to account for non-recurring, non-operating, or discretionary expenses such as above- or below-market owner compensation, one-time legal fees, or gains and losses from asset sales. These adjustments aim to present a clearer picture of the company’s sustainable earnings.

 

Equally important is selecting the appropriate EBITDA time frame. Trailing twelve months (TTM) is commonly used because it reflects the most recent operating performance, but a historical average may be more appropriate for cyclical businesses or those with fluctuating results. Pro forma EBITDA can also be useful when recent changes—like cost-saving initiatives or acquisitions—are expected to significantly alter future performance. Each choice has implications for how reliable and relevant the multiple becomes in the valuation process.

 

What are the method’s inherent strengths and potential pitfalls?

 

The advantages of using an EBITDA-based approach include the following:

 

  • Ease of application – An owner or advisor can calculate EBITDA and apply a chosen multiple to determine the enterprise value of a company.
  • Simplifies negotiation – In a transaction, using EBITDA provides both the buyer and seller with a common earnings number from which to negotiate and apply a multiple, thereby reducing negotiation points.
  • Reduces the impact of accounting and financing differences – Differences in accounting (such as depreciation and amortization), financing (such as interest expense levels), and tax status between companies can affect net income. Using earnings before interest, taxes, depreciation, and amortization makes earnings more comparable by diminishing these differences.

 

Using an EBITDA-based approach can sometimes lead to a superficial analysis of a company's value. This method might give the impression of having an accurate valuation without thoroughly examining all relevant factors. The key distinctions to consider include:

 

  • Growth – A company's value is based on expected future benefits (i.e., cash flow) to the investor or capital provider. Higher or lower growth can significantly impact the multiple. An average EBITDA multiple applied to historical earnings might not adequately reflect expected growth.
  • Investment requirements – While EBITDA can be a proxy for cash flow, it does not represent actual cash flow, which includes investment needs. Typical investment requirements are working capital (current assets minus current liabilities) and capital expenditures. These can be substantial depending on the industry, resulting in a significant difference in cash flow relative to EBITDA.
  • Risk – Investors require a return that justifies the assumed investment risk. Adjustments to the EBITDA multiple should be made to reflect this risk difference.

 

Summary

 

Using an EBITDA multiple as a valuation tool offers clear advantages, but it also comes with important limitations. To use it effectively, advisors and business owners must conduct thorough research into both the company and its industry and apply it alongside other appropriate valuation methods. Does EBITDA solve valuation challenges? Sometimes—but only when combined with careful due diligence and complementary techniques. Relying on EBITDA alone, without proper context or adjustments, can result in misleading conclusions.