EBITDA Rethought
Valuing a company is as much an art as it is a science. In this article I’ll walk through the basic steps of calculating the enterprise value of one’s business using the EBITDA multiple:
1. Calculate one’s EBITDA.
2. Make the necessary adjustments to one’s EBITDA.
3. Determine an appropriate EBITDA multiple based on peer group or comparable entities.
4. Calculate one’s enterprise value.
5. Derive one’s market value of equity from enterprise value.
Consultants love their acronyms: ROI, NPAT, EPS, CAPEX, etc. Not sure if the acronyms are meant to impress, confuse or to impart “specialized” knowledge. In truth, finance and accounting are quite straightforward. EBITDA is yet another acronym; however, EBITDA isn’t easily calculated and falls into the category of (lesser used) valuation metrics! I’ve yet to hear a business owner refer to his company’s EBITDA ratio when discussion his asset turnover, leverage, liquidity or other more widely used metrics.
EBITDA is somewhat of the red-haired stepchild for the acronyms used more regularly – typically pulled from the acronym stockpile only when a potential sale is afoot. In addition, calculating a company’s EBITDA isn’t as easy as the more commonly calculated financial metrics, as we’ll see below. And it’s not as easily “unpacked” either, which renders its use far more limited.
Spoiler alert – EBITDA, while a widely used valuation metric, has a number of components that make valuation imprecise. The largest shortcoming is in the multiple applied as the range of multiples varies widely. Justification of a multiple that both seller and buyer agree on depends on further financial and operational metrics.
We’ll first present a calculation of EBITDA using a very simple example. Next, we’ll discuss the complexities of determining Enterprise Value (EBITDA multiplied by a multiple). Finally, we arrive on Shareholder Value (another tweak to Enterprise Value) as in most cases, this is what a seller receives from the sale of his/her company.
In its most basic form, EBITDA is calculated as follows:
In the example above, this company’s NPAT is $2,316 but its EBITDA is $3,326 – a significant difference. Thus, EBITDA is a variant of traditionally defined operating income as it adds back non-operating and non-cash expenses. EBITDA focuses on a company's operational decisions because it examines the profitability of the company's core activities before accounting for capital structure, leverage, and non-cash expenses like depreciation.
Now that we’ve determined our sample entity’s EBITDA, the more challenging tasks are (a) making any required/appropriate adjustments to EBITDA and (b) landing on an applicable multiple.
Making the required/appropriate EBITDA adjustments (if any) is where the art comes into play as opinions differ on what should be added back to derive EBITDA. Usually such items are on a case-by-case situation, but the following are typical:
The seller’s salary and perks
The salary and perks of any family members (to market value)
Market rent price if you are the owner of the facilities and don’t pay for it
Personal expenses (e.g., mobile phone, childcare, travel)
Non-recurring items, such as litigation cost, facility moves, one-off professional fees
Expenses or income that isn’t expected to continue after the sale
Adjusting EBITDA helps obtain a normalized and accurate figure not impacted by irregular gains, losses, and other factors. Failing to adjust EBITDA may result in an incomplete representation of your company’s true earnings potential, leading to a lower valuation.
So far, so good. The calculation of un-adjusted EBITDA is widely accepted among practitioners as are necessary/relevant adjustments. The most challenging part of determining the value of a business is determining the correct EBITDA multiple, especially if you are looking for private company valuation multiples. The most common approaches to finding the suitable EBITDA multiple are the following:
Comparable company analysis: this approach is commonly used by investors and includes looking at the average EBITDA multiple for the industry or peer group. Deep industry knowledge and thorough research is required to find the right comparable companies to include in the calculation. Also, the resulting EBITDA multiple may need to be adjusted for differences in characteristics and operations.
Precedent M&A Transactions: this approach is generally applied when valuation is for M&A purposes, and it looks at the valuation multiples used in any preceding transactions. It can also be applied if many recent transactions of companies with similar size and scope have taken place. However, it’s important to remember that financial details for private company deals are limited, and adjustments must be made to account for any premiums or discounts for obvious differences.
A word as to multiples – there is no single, or simply-determined, multiple that can be pulled from the shelf. Generally speaking, private companies sell between 2X and 10X EBITDA, with most transactions settling between 4X to 6X. Here’s where the real analysis and negotiations get going, quickly. Sellers need to have answers to the following to maximize the valuation they seek.
Historical and projected growth – growth in top line revenue, and profit, are among the most important multiple-driving factors. Historical growth at least 10 percent (far better if over 20 percent) will (all things being equal) garner a multiple closer to the top of the range.
Recurring revenue – sellers with well-established revenue that is likely to continue without a costly sales effort can argue a strong case for a higher multiple.
Unique product or service – sellers should build the case for having a unique product or service, one that is less of a commodity, to present the case for a higher multiple (and to attract more suitors.
Customer concentration – having recurring customers is obviously a positive, high-multiple-justifying attribute. However, a small number of large customers (any one representing more than 20 percent) is viewed as risky.
Depth and strength of company management – this attribute is obvious, as is having a well-tenured group of employees.
A strong supporting cast – depending on the seller’s industry, having strong “supporting” financial metrics. I’m a fan of the Dupont model for example, where return on assets multiplied by financial leverage explains ROI. Unpacking ROA and leverage touches on all factors driving a company’s financial performance. And identifies any weak links.
Scott Tindall / Advisor
stindall@breakawayba.com
The final step is to (once again) tweak what started out as a straightforward EBITDA calculation and then morphed into Enterprise Value. This step is quite simple (no basis for contesting it) since Enterprise Value is adjusted for the company’s net debt (the difference between outstanding borrowings and cash plus cash equivalents). Finally, one must subtract the amount of any preferred shares and minority interest.
The journey’s end should be where all professionally managed companies should operate – with strong financial reporting and diligent use of relevant financial metrics (such as those underlying a DuPont analysis approach) as the better financially managed your company is the better performing it will be. There’s little new under the sun.