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.
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.
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:
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 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:
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:
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.