Insights

Valuation 101: the EBITDA Multiple

April 30, 2019 //

Last month we took a high-level look at different approaches to valuing a company. We noted that, because of their ability to reflect the future economic benefits of an ongoing business, cash flow methodologies are most commonly used in business valuation. These include applying a multiple to an income or cash flow number, capitalizing cash flows, and discounting cash flows. In this article, we look at the most frequently referenced and easy to apply technique: the EBITDA Multiple.

What is the EBITDA Multiple?

The EBITDA Multiple is best considered a rule of thumb, a quick way to estimate business value by applying a discount rate to a measure of cash flow. Its simplicity and apparent ease of comparison across transactions and industries have made this a frequently reported measure in M&A discussions and the business press. 

The basic calculation is: Normalized EBITDA x EBITDA Multiple … where a company’s EBITDA is adjusted to remove discretionary or non-recurring expenses, and the multiple reflects the required return on capital or discount rate. Figure 1 provides more detail.

Normalized EBITDA

EBITDA represents a business’s operating cash flow independent of financing, income taxes, or capital expenditures. Because for valuation purposes we are trying to estimate future cash flows, adjustments may be necessary to remove revenues or costs that the buyer would be unlikely to incur. Examples include:

  • Unusual or non-recurring revenues or expenses – e.g., start-up costs for new product lines or additional production capacity; relocation costs; restructuring costs; proceeds from the sale of a division
  • Discretionary expenditures – e.g., owner’s personal travel or property that is expensed through the business
  • Income or costs relating to redundant assets – e.g., real estate; a company plane
  • Non-arms length income or costs incurred above or below market rates – e.g., rental payments to or purchases of goods or services from related parties

Also in the service of estimating future cash flows, EBITDA may be calculated using historic, current, or even projected future operating results – or a weighted average of the three.  If a business has recently added significant new product lines, current or future cash flow numbers may provide better insights into the future than historic ones. Conversely, if it is operating in a highly cyclical industry, historic results may paint a more accurate picture than current ones.

The Multiple

The EBITDA multiple is the inverse of your required rate of return on capital, independent of income taxes or capital expenditures. As Figure 2 illustrates, the higher the rate of return needed (implying higher risk), the lower the multiple.

EBITDA multiples for recent transactions are widely reported by quarter, industry, and transaction size. Figure 3 shows a recent example. While these published numbers give the impression of objectivity and accuracy, they should be treated with caution. Published multiples are almost always higher than actual ones. The inclusion of earn-outs and other contingent payments before they are earned means that transaction values are often overstated. EBITDA is often reported without the normalizing adjustments. And industry is a very rough approach to identifying truly comparable transactions.

To determine a sensible multiple, we must take the following factors into account:

  • Company-specific factors – e.g., strengths and opportunities; weaknesses and threats; uniqueness of products; barriers to entry; competitive advantage; revenue stability and diversification; management team strength; overall risk; company size; growth expectations; capital expenditure requirements; growth capacity
  • Industry characteristics – e.g., cyclicality; competitive landscape; barriers to entry; risk posed by suppliers and customers
  • Economic and capital market conditions – e.g., GDP growth and other economic indicators; point in capital market cycles; access to equity and debt
  • Comparable public companies – public equity market trading multiples
  • Industry transactions – M&A transactions of the type reflected in Figure 3
  • Transactions involving the specific business – multiples paid in the recent purchase or sale of company assets, divisions or business lines

Limitations

The benefits of the EBITDA multiple are that it is simple, easy to calculate, widely recognized. But it has serious drawbacks that make it of limited use to a sophisticated advisor or serious buyer:

  • Efforts and analysis tend to be overly focused on the multiple and overlook the many decisions going into the EBITDA number. With no consistent standard, adjustments can be used to inflate value or knock it down.
  • Adjustments to calculate the EBITDA are inconsistently applied across companies, often ignored in published averages, and typically hard for an outsider to evaluate.
  • Applying published multiples to a company’s EBITDA tends to yield an inflated number. In addition to the reasons described above, large companies tend to attract higher multiples than smaller ones, and public companies higher than private ones.
  • Many factors are incorporated into a highly subjective multiple, from perceived risk to capital market buoyancy to management team strength to a special buyer’s assessment of potential synergies. Unless you know what buyer is thinking, it is easy to misinterpret the multiple and resulting valuation. This also makes it hard to properly compare across transactions.

We recommend that the EBITDA multiple be used as just one of several approaches to valuing a company and treated as a rough estimate at best. In the next article we will examine a much stronger valuation alternative to the EBITDA multiple: discounted cash flow.