January 4, 2018 //
In today’s M&A environment, an EBITDA multiple is by far the most common methodology employed to value a privately owned business. It is used because of its simplicity and ease of calculation. In its basic form, the formula is:
EBITDA Multiple x Adjusted EBITDA = Debt-free Enterprise Value
These days, almost every valuation discussion with business owners and acquirers seems to focus entirely on the EBITDA multiple portion of the formula. This is understandable because there is widespread reporting of EBITDA multiples – its quarterly trends, averages by industry, mid points based on transaction size, etc.
But Mark Twain’s words, “There are three kinds of lies – lies, damn lies and statistics,” ring very true in using Reported EBITDA multiples.
A recent review comparing published EBITDA multiples to the actual multiples that were used to calculate transaction values showed a marked gap between these multiples. Not surprisingly, in almost every case the published multiples are higher. The question, in the words of Boston Legal’s Alan Shore, is “Now why is that?”
The starting point is to understand how EBITDA multiples are calculated. Reporting agencies generally use the following formula to calculate Reported EBITDA Multiples:
Reported Transaction Value / Reported EBITDA = Reported EBITDA Multiple
Seems simple enough, but the devil is in the details. There are three factors that distort the calculation of the EBITDA multiple in this formula.
We recently sold a business through a strong competitive bidding process. The price was determined as follows:
[(1) $500,000 increase in EBITDA by end of year 1 ($2,500,000 – $2,000,000) x 5.0 (multiple) = $2,500,000 earnout payment]
Using the same information, reporting agencies would have calculated the Reported EBITDA multiple as follows:
The same transaction, but two very different EBITDA multiples – the negotiated EBITDA multiple used to calculate the actual purchase price was 5.0 whereas the Reported EBITDA multiple was 7.78.
So – what was the actual EBITDA multiple for this transaction? Clearly, the actual multiple of 5.0 times is the answer; however, this number is never reported and herein lies the EBITDA Multiple Trap.
The EBITDA Multiple Trap
What if the business owners had used published EBITDA multiples to establish their valuation expectations? They would have been significantly over market.
[(1) $500,000 increase in EBITDA by end of year 1 ($2,500,000 – $2,000,000) x 7.78 (multiple) = $3,890,000 earnout payment]
There is a striking and vast gap between the actual market value ($14,000,000) and the Expected Market Value ($20,950,000). One can easily see why many business owners have experienced great disappointment in buyers’ assessment of the value of their business and many “market value” offers have been rejected because owners and their inexperienced advisors have used Reported EBITDA multiples.
The best approach to using the EBITDA multiple method of valuation is: