What is EBITDA? Why is an EBITDA Multiple Important?

Sometimes there is confusion about EBITDA or "Earnings Before Interest TaxesDepreciation and Amortization" and why an EBITDA multiple is important in a company valuation.

Let's start with explaining EBITDA and then we will understand how it's important in determining the value of a company. Many people are familiar with the term, but a business owner may not understand how to calculate EBITDA for their own company. One of the purposes of calculating EBITDA is to get to a cash flow number which can be compared to others in your industry. It is also a number which a buyer would expect to earn from the company after the sale.

First, you need to start with your earnings, which could also be called net income, income after taxes, profits, profits after taxes. You get the idea; it's basically your bottom line or what you have left over from your company revenues after you take out all of the "reasonable" expenses. Not the expenses for your Tesla, vacation home or extravagant eating habits. 

Ok, so now we have the "E" and "B" - earnings before...

Next you add back some items - "I" - such as interest on bank loans or debt and - "T"- taxes. You also want to add back - "D" and "A" - depreciation and amortization which are basically non-cash expenses.

The point of EBITDA is to compare companies by the same metric, so you can see the profitability and cash flow of the company compared to other companies in the same industry. This means we eliminate factors a business owner has discretion over, such as the type of debt financing and capital structure, whether it's taxed as an S-corporation or C-corporation and if the assets are depreciated using acceleration methods such as Section 179 depreciation.

Buyers will also look at adjusted EBITDA, which is calculated by reviewing the financial statements and determining if there are owners’ discretionary items such as higher salaries for management, perquisites such as cars and any other non-operating items. Non-operating expenses are not necessary for the business to function, such as vacation homes, first class travel, sports season tickets and such. There are adjustments for non-recurring income or expenses such as loss from a fire or income from the sale of certain assets. These items are not likely to happen again. Basically a buyer would look to “normalize” or adjust EBITDA for all of the expenses and/or income, which may not continue into the future. Once you eliminate some of these items then you can look at your company's EBITDA and apply a multiple derived from industry transactions, mergers and acquisitions.

In the valuation of the company there are three methods to consider and one of them is the market approach. This approach uses various market multiples, basically what companies have sold for in the open market, to determine the value of company. One valuation multiple is the sales price divided by EBITDA or also known as an EBITDA multiple.

For example, buyers may pay six to seven (6-7) times EBITDA in a certain industry. This means that the value of the company would be in the range of six to seven multiplied by your company’s EBITDA number. How do you determine the multiple? Well valuation experts have extensive databases of transactions. We search based on the industry code and then will select multiples for sales of companies similar to your business in size, location, revenue, profitability and other factors. We work to find evidence of other sales which would indicate what your company may sell for in the open market. Of course it's not always a simple calculation because a buyer would consider many factors in order to determine what they would pay for your particular company, such as synergistic elements, but it does give you an idea of the cash flow and value.

In the sale of a business there may be other adjustments regarding balance sheet items. For example, if you have excess cash in the business in the form of investments or cash in the bank, not needed for the operations, you could add this cash to the value of the company. A buyer would not take the cash with them at the point of sale. There may also be some liabilities or debts for which the buyer will not assume, such as debts owed to shareholders. So there could be additional adjustments to the value, which a valuation expert could help you understand during a formal valuation process.

In order to plan for a future exit of your business it's not only important to understand the market multiples in your industry but also understand your company’s EBITDA level historically as well as earnings going forward. Most buyers will want to see three to five years of financial information, so it is best to know what trends they will see before you start the selling process.

If you'd like to know more about how to value a company or if you are selling a business and have some questions about the value give me a call at 314-541-8163.

This information should not be construed as investment or legal advice, just one expert’s perspective.

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If you own a business and are getting divorced you may consider your current CPA to value your business. Here are some questions to ask!

Business Valuation Methods: Income Approach and DCF Model - Company Valuation Expert in St. Louis

One of the approaches business valuation companies will consider when providing a valuation of a company is the "Income Approach".

The income approach considers historical income, future revenues of a company, the earning potential and also capital requirements, or how much will be needed to invest in the building and equipment to support future revenue growth. 

There are a couple of ways to look at the potential income of a company. One business valuation method which falls under the Income approach is the discounted net cash flow or DCF method. This method involves projecting the revenues, cost of goods sold, operating expenses, depreciation, working capital and taxes for five to ten years into the future. 

The next step is to discount this future revenue stream to the present, which most of you will recognize as a present value calculation. The discount rate is derived from several methods such as the build up model or CAPM for example. The business valuation expert will also have to take into consideration whether this is a control or minority interest and make an adjustment with a control premium or a discount for lack of control. These are business valuation terms...which we discuss in more detail in other videos. 

There can also be situations where there are liquidity or marketability issues for stock in closely held businesses. There are discounts for lack of marketability to cover these issues.  As you can see there are many steps to consider when valuing a company from the income approach, but at least now you know enough to be dangerous. 

If you would like more information on business valuations, methods to value a company or how to find reputable business valuation companies in Chicago, New York or St. Louis call us at 314-541-8163 or you can find additional videos on company valuation issues at http://www.YouTube.com/businessvaluationSTL

Filing for Divorce: Hire your current CPA or a Valuation Expert in Divorce Court?

Many people have valuation questions when filing for divorce. One of the main questions is whether or not they should use their current CPA to provide valuation services or expert witness testimony in family law court.

Many people going through divorce assume that since their accountant or CPA has worked with them for many years then it would make sense to use them to prove the value of the business, provide maintenance calculations, or testify in court.

The reality is that alimony, child support and company valuation issues are complicated matters. Business valuations are usually handled by people who have many years of experience and a business valuation credential such as CVA, ABV or ASA which are just some of the available certifications.

So the first question you need to ask your CPA, accountant or bookkeeper is whether they've completed any business valuations in the past. Another good question is whether they have received any formal training regarding business valuation methods.

Another good question to ask is if they have some experience in providing valuation services to other companies.  The next question could be whether they have ever testified in deposition or trial for a divorce proceeding.

It is one thing to be able to give someone a rough estimate of value and it is quite another to truly understanding business valuation methods and to be able to complete a full valuation of a company. It is a whole different matter to able to testify regarding the valuation report or calculations.

There are several areas of valuation which are important when testifying in divorce court. Most professional valuation experts are well-versed in applicable court cases, the difference between personal and enterprise or business goodwill.

For divorce it is importance that the expert understands the rules for each state within which they work. Typically this requires some experience or prior testimony in the family law area.