EBITDA Valuation—What Is It?
Posted by Valentiam Group on September 8, 2020
One of the most common metrics for business valuation is EBITDA. Appraisers can use this metric to perform an EBITDA valuation, comparing the Subject Company’s performance and value against similar companies. In this article, we’ll examine what EBITDA and EBITDA multiples are, and how to calculate company value based on EBITDA using the EBITDA multiple method.
What is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation, and amortization. It is an indicator to measure business financial performance that is often used by prospective buyers or investors.
This simple formula is used for calculating EBITDA:
Operating profit + Depreciation + Amortization = EBITDA
Application of this formula eliminates the non-operating effects unique to each business. Calculating the EBITDA company value allows comparisons of companies across different industries and tax brackets by focusing on profitability as the measure of business performance. EBITDA reflects financial performance in terms of profitability prior to non-operational expenses. A high EBITDA margin illustrates that the company’s operating expenses are smaller than its total revenues, meaning it is profitable.
EBITDA functions as a stand-in for the company’s enterprise value, or its total value, including common shares and equity, short-term and long-term debts, minority interest, and preferred equity. Enterprise value is the sum of all financial claims against the company, whether they are debt or equity.
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The EBITDA Valuation Model
When valuing a company using EBITDA, the appraiser will first calculate the Subject Company’s EBITDA, then use EBITDA multiples to estimate value.
These multiples are derived from market data on publicly-traded comparable companies as well as data about transactions, mergers, and acquisitions of comparable companies in the same industry and of similar size to the Subject Company. Examination of this data will allow the appraiser to come up with a representative range, and, with the application of judgement and experience, to zero in on the multiple range relevant to the Subject Company.
EBITDA multiples are easy to derive from financial statements. Operating income before depreciation can be established by looking up the sum of a company’s stock market value, its outstanding debt, and its cash on the balance sheet to determine the multiple.
Application of multiples allows comparison between companies of different sizes and in different industries. The appraiser will zero in on the multiple range most appropriate for the Subject Company by consulting publicly available information regarding the EBITDA multiple ranges for the industry. Higher potential for future growth will typically equate to a higher multiple, and larger companies or those with higher profitability will generally have higher multiples than smaller ones, because they pose lower risk for investors. This lower risk profile usually translates into a higher EBITDA multiple.
Average EBITDA multiples vary widely by industry, reflecting the potential for future growth and the stability of the industry. Examples of industry-specific EBITDA multiple averages are shown below; multiples for specific companies within these industries will vary according to company size:
Average EBITDA Multiple
Food Retail & Distribution
Oil & Gas Exploration and Production
Professional Information Services
The averages for the industries in the table above illustrate how the effects of growth potential, profitability, risk, and stability in various industries impact average EBITDA multiples.
- The average multiple value for electric utilities reflects both stability and size; utility companies have fairly constant demand and tend to be large companies with a lot of physical assets.
- Food retail and distribution is stable, since all people need food, but it is a low profit margin and low growth industry, which is reflected in a lower average multiple.
- Oil and gas exploration and production has a much lower average multiple, reflecting the inherent risk in the industry, where millions of dollars can be required to drill a well that is never productive; the industry is also subject to a high degree of economically sensitive demand.
- Software and professional information services (data analytics), on the other hand, are both cutting-edge industries, which is indicated by very high average multiples, since the potential for innovation and growth is high and such businesses tend to be very profitable because of high switching costs.
Note that these multiple values were calculated pre-COVID-19; economic conditions in the wake of the pandemic have without doubt impacted the average multiples for various industries in different ways and to varying degrees.
Appraiser judgement is critical when applying EBITDA multiples, to ensure that the multiple applied does not significantly over- or under-estimate value. It’s also important to align EBITDA values by using the same time period for the comparison.
For example, if the appraiser is using past or historic results for the Subject Company, the EBITDA from that time period should be compared to the past or historic results from similar companies in the same time period. If the EBITDA is forecasted, it should be compared to forecasted EBITDA values for similar companies. This eliminates the effects of the business cycle; clearly the EBITDA value calculated for a Subject Company in the post-COVID-19 pandemic period cannot be compared to the EBITDA values of similar companies in the pre-pandemic period, when economic conditions were much more favorable, without introducing a large discrepancy in value.
Disadvantages Of EBITDA Valuation
Though EBITDA multiple valuation offers an easy way to estimate value, the EBITDA valuation model has a significant downside: It is only an estimate.
EBITDA does not by itself establish a direct value for the Subject Company. It is an approximation of enterprise value that allows an estimation of value through comparison to other companies. EBITDA valuation is as a result subject to the same limitations as the market approach for determining value. The multiples for peer companies are at best an approximation of value, because the Subject Company is likely to be significantly different in one or more ways. Incomplete information about transactions can also lead to error.
Another major drawback is that EBITDA does not have an official GAAP (Generally Accepted Accounting Practice) definition. Due to the lack of an official definition, EBITDA can be subject to misrepresentation by business managers or others.
As a result of these factors, the EBITDA method of valuation carries a significant risk of error. While it can be a quick and easy way to approximate enterprise value, it is just that—an approximation, not a detailed valuation.
Best Uses For The EBITDA Method Of Valuation
Because EBITDA valuation is an approximation, it is not suited to situations where a defensible valuation is required, such as for tax purposes. Since EBITDA is not defined by GAAP, for any purpose where a GAAP-compliant valuation is necessary, valuing a company using EBITDA will not be sufficient.
But there are situations where equating EBITDA to company value is useful. EBITDA valuation is used extensively in mergers and acquisitions (M&A), often to identify attractive takeover candidates. Companies with low EBITDA multiples can be good candidates for acquisition; when the value of the EBITDA ratio is low in comparison to similar companies, it signals to investors that the company is undervalued and thus, potentially a good investment. (The opposite also holds true—a high EBITDA ratio is a red flag, indicating that the business is overvalued.) EBITDA multiples are routinely used by equity research analysts and fund managers to guide investment decisions, and are used by investment bankers to advise on M&A transactions.
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Topics: Business valuation