There are many ways that investors measure a company’s financial health before or during an acquisition or merger. However, EBITDA is one of the most common metrics that investors use to determine a company’s value.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a non-GAAP business valuation metric in financial analysis that gives a more accurate reflection of a company’s operational efficiency and profitability. Calculating EBITDA removes non-operating effects unique to each business and helps focus on the operating profitability of the company, giving better insight into the company’s finances as the singular measure of performance. EBITDA is important during mergers and acquisitions since it helps make meaningful comparisons for firms with different capital, investment, debt, and tax profiles. This makes M&A processes smoother and more efficient.
In this blog, we explain how to calculate EBITDA, EBITDA multiples, adjustments, the importance of valuing your business on EBITDA, and what EBITDA suits your business.
The Basics of Calculating EBITDA
There are two ways of calculating your company’s EBITDA; using operating income as the basis or net income as the starting point.
When using operating income:
EBITDA = Operating Income (gross income minus operating expenses such as wages and cost of goods) + Depreciation + Amortization.
And when using net income:
EBITDA = Net Income + Taxes + Interest + Depreciation + Amortization.
However, it is worth noting that the two formulas can give different results since some items included in net income might be excluded from operating income. Typically, adjustments are made to these formulas to yield more reliable results and normalize EBITDA.
Normalizing adjustments are critical in coming up with adjusted EBITDA before applying a multiple to the figure to determine the value of a business.
EBITDA adjustments also help determine the business’s underlying earnings capacity after the merger or acquisition is completed. Some of the common add-backs and EBITDA adjustments can include:
- Non-recurring items are expenses that are unlikely to occur again in the future. Examples of non-recurring expenses may include legal expenses, consulting or other professional fees, transaction-related costs, one-time technology upgrades, facility relocation expenses, bad debt expenses, and donations, among others,
- Owner discretionary items such as salary and allowances, management considerations, and other owner-related expenses.
- Non-operating items are expenses that are not required in or related to the true operating performance of the company. Oftentimes, these are related to non-operating assets or liabilities, such as real estate or vehicles.
EBITDA Valuation Multiples
The EBITDA Valuation Multiple offers a great starting point when you want to sell your company, merge with another or buy one. It helps measure the potential value a business will command during an M&A process. The EBITDA multiple is a market-based valuation strategy that compares a company’s enterprise or economic value to its yearly EBITDA.
Enterprise Value = (market capitalization + debt value + minority interest + preferred shares) – (cash and cash equivalents)
EBITDA Multiple = Enterprise Value/EBITDA
EBITDA multiples are statistically derived ratios obtained from the most recent comparable business sales or from comparable public companies. These multiples vary from one company to another, depending on the potential for growth, industry of operation, and size. Typically, firms and industries with better prospects for growth in the future have higher EBITDA multiple values. Consequently, well-established businesses will have higher multiples than early-stage and small companies.
EBITDA Multiples Vary
EBITDA Multiples also vary greatly by industry since industries tend to differ in expected growth rates, profitability margins, stability, and recession resistance, all of which are considered when calculating these multiples. These differences can be attributed to:
- The variation in potential for growth in different industries. Businesses in high-growth sectors such as E-commerce are likely to have a higher EBITDA multiple.
- Higher profitability in some industries like software translates to a higher EBITDA margin (EBITDA/Revenue), and thus a higher EBITDA multiple.
- Stability in terms of profits, yielding a higher EBITDA multiple. This means that buyers and sellers are at a lower risk of losses.
On the other hand, industries with higher risks are sensitive to economic dynamics, and low profitability registers low EBITDA multiples. However, it is also worth noting that prevailing market conditions also affect EBITDA multiples. The current Covid-19 pandemic is a perfect example, which has affected almost every industry in the global economy.
Even though their variations by industry can help indicate and predict growth, stability, and profitability, thus the valuation of the business, EBITDA valuation multiples are only estimations and do not give the actual value of a firm. Additionally, relying on EBITDA as a measure of a firm’s cash flow ignores other significant factors which can impact a company’s cash flow, such as changes in working capital and capital expenditures.
What EBITDA Multiple Is Right for My Business?
EBITDA multiples are highly applicable for businesses in, but not limited to, manufacturing, distribution and wholesale, real estate, and information technology. If your business falls under these categories, you can use EBITDA multiples to estimate the value of your business. It is advisable to seek the services of a professional to help you determine the multiple applicable to your business.
Contact Lutz M&A
Business valuation is critical during M&A. With the help of an advisor, such as Lutz M&A, you can set your business up for success. Contact us today if you have any questions or want to learn more about our merger and acquisition services.