Sometimes there is confusion about EBITDA or "Earnings Before Interest Taxes Depreciation 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.