EBITDA valuation, which compares the performance and value of the Subject Company to that of similar companies. In this post, we’ll look at what EBITDA and EBITDA multiples are, as well as how to use the EBITDA multiple approach to assess firm value based on EBITDA.
What is EBITDA?
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is the acronym for earnings before interest, taxes, depreciation, and amortization. It is a metric used by prospective purchasers and investors to assess a company’s financial performance.
EBITDA is calculated using this simple formula:
Operating profit + Depreciation + Amortization = EBITDA
The use of this formula eliminates the non-operating effects that are unique to each company. By focusing on profitability as a measure of business performance, the EBITDA company value permits comparisons of organizations across industries and tax levels. EBITDA is a financial metric that measures profitability before non-operational costs. A high EBITDA margin means the company’s operational expenses are less than its total revenues, indicating profitability.
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.
The EBITDA Valuation Model
When valuing a business using EBITDA, the appraiser will first compute the Subject Company’s EBITDA before estimating value using EBITDA multiples.
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.
The use of multiples enables for comparisons across businesses of various sizes and industries. By analyzing publicly accessible information about EBITDA multiple ranges for the industry, the appraiser will home down on the multiple range that is most appropriate for the Subject Company. A greater multiple equates to a higher possibility for future growth, and larger organizations or those with higher profitability will normally have higher multiples than smaller companies, as they provide less risk to investors. A larger EBITDA multiple is usually associated with a lower risk profile.
- 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.
If the appraiser is using past or historic results for the Subject Company, the EBITDA from that time period should be compared to similar companies’ past or historic results from the same time period. If EBITDA is projected, it should be compared to similar companies’ forecasted EBITDA figures. This removes 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 significant value discrepancy.
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 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
EBITDA valuation is not suitable for circumstances when a defensible valuation is required, such as for tax purposes, because it is an approximation. Because EBITDA is not defined by GAAP, valuing a firm using EBITDA will not suffice for any purpose where a GAAP-compliant valuation is required.
However, there are times when comparing EBITDA to corporate value is beneficial. In mergers and acquisitions (M&A), EBITDA valuation is frequently used to find promising takeover candidates. Low EBITDA multiples can be ideal acquisition targets; when the EBITDA ratio is low in relation to similar companies, it signals to investors that the company is undervalued and hence a potentially good investment. (A high EBITDA ratio, on the other hand, is a warning sign that the company is overvalued.) Equity research analysts and fund managers utilize EBITDA multiples to assist investment decisions, and investment banks employ them as well. 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.