Understanding EBITDA Business Valuation

When it comes to weighing up businesses and making decisions such as which to buy and what to pay for them, it helps to have a level playing field that allows you to establish and compare company valuation in as fair a way as possible. While a variety of valuation methods may be utilised, a common way of attempting to establish that level playing field is to use EBITDA.

What is EBITDA?

EBITDA is earnings before interest, tax, depreciation, and amortization. It shows the profitability of the company before items the owner has control over are introduced.

Interest: this is interest expenses charged on, for example, loans (the owner has control over this as they signed the loan agreement).

Tax: this is taxes due – but bear in mind tax can be (and usually is) mitigated.

Depreciation: as tangible assets – plant and machinery, for example – age, they are likely to be reduced in value until they are written off.

Amortisation: the value of intangible assets – intellectual property or software, for example – is also subject to a reduction in value until written off.

EBITDA puts all of these things to one side and looks at the value of a company based on earnings. The resulting figure reflects operating profitability which allows comparison with other companies.

EBITDA and Business Valuation

EBITDA represents the earnings of a company before non-operating costs (interest and tax) and non-cash expenses (depreciation and amortization) are taken into consideration. It gives a consistent picture, over time, of the business’s operating performance, indicating how much the business is worth in terms of cash flow, assets, and market position.

It can be especially useful when valuing private companies as, unlike public companies, their financial performance metrics are not made widely available, making establishing market value trickier.

As well as valuing any one particular small business, EBITDA allows for comparisons to be made between companies in the same sector or industry.

Industry-Specific EBITDA Multiples

Businesses are valued on a multiple of EBITDA, but the multiplier used can vary depending on a number of things. One of those things is the industry in which the business operates.

A ‘hot’ industry business, such as perhaps medical technology, will be valued at a higher EBITDA multiple than something like a hairdressing salon or hardware store.

In the UK, in the first quarter of 2023, it was reported that EBITDA valuation multiples ranged from 3.3 for construction and engineering to 8.1 for software development.

The industry multiple is also known as the enterprise value (EV).

Adjusted EBITDA

One thing to take into account with EBITDA valuation is that if there is unusual income or expenditure in the most recent set of accounts, and those are the figures the business owners supplied to work out EBITDA, then the figure will be skewed. If unusual income is included, this will inflate EBITDA and favour the seller. If unusual expenses are included, this will depress EBITDA and favour the buyer.

The way to mitigate that is to calculate normalised earnings, resulting in an adjusted, and more typical, EBITDA. This is done by removing or adjusting unusual income and expenditure.

The kinds of things likely to be affected include:

Exceptional expenditure: one-time expenses not typically incurred, such as redundancy or legal payments, will be removed.

Exceptional income: one-time income not typically received, such as income from sale of assets, will be removed.

Related party transactions: any arrangement the business has with a related party or entity that differs from normal market terms, such as supplier discounts or reduced rent, will need to be adjusted to reflect market rate, as that is what will be paid post-acquisition.

Discontinued operations: costs and income related to products and/or services that will not be offered post-acquisition will be removed.

Personal expenses: if the owner has been putting personal expenses through the business, these will need to be removed.

Remuneration anomalies: if key staff are taking a salary below market rate, or shareholders are taking money out as dividends, this will need to be adjusted.

Key Financial Metrics Related to EBITDA

EBITDA Margins and Ratios

The debt to EBITDA ratio indicates the ability of a business to pay its debts. A high ratio would be cause for concern and indicate the company might be carrying too much debt. Excessive liabilities are a red flag.

EBITDA margin concentrates on core profitability and cash flows. It indicates how efficient a business is at converting revenue into operating profits.

EBITDA margin = (EBITDA ÷ Total Revenue) x 100

As a general rule, over 10% is considered good. That said, the measure of what is a good margin can vary by industry/sector, so it’s best to compare the figure with similar companies in the same arena.

EBITDA vs. Other Financial Metrics

Operating income, also known as EBIT (earnings before interest and taxes), is a company’s revenue minus the cost of goods sold (COGS) and operating expenses.

EBITDA strips out additional expenses.

Both can be used to give a deeper understanding of value. Whereas EBITDA focuses on profitability, operating income can help analyse production efficiency.

Net income is the bottom line; it’s what is left from gross income following deduction of all expenses. As such, it’s more precise than EBITDA.

Both net income and EBITDA are financial metrics used to assess business performance. While both measure a company’s earnings and subtract COGS, they differ in how they account for expenses.

Operating income is a measure of a company’s core operations, while net income is a full measure of a company’s profitability. Operating income is usually higher than net income because net income often deducts more expenses.

How to Calculate EBITDA

The first step is to gather the necessary data. Financial statements will prove useful here.

Obtain the Business’s Income Statement

The income statement, also known as a profit and loss statement, is a historical record of a company’s financial performance over a specific period of time, usually one year. It shows the profit or loss made by the business.

Identify Relevant Financial Figures

To calculate a company’s EBITDA, you will need to obtain the relevant figures for the target business. The income statement should have everything you need.

Calculate EBITDA

EBITDA is calculated by adding back interest, taxes, depreciation, and amortization to a company’s net income:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

It can be calculated for an accounting period, with last twelve months being commonly used.

Advantages and Disadvantages of Using EBITDA

As with most things, there are both advantages and disadvantages associated with relying on EBITDA.

Advantages of using EBITDA

On the plus side:

• EBITDA valuation offers a relatively quick and easy way to identify potential acquisition targets.
• It allows for easy comparison of similar businesses operating within the same sector or industry by removing variables that differ from business to business.
• Because it excludes non-operating costs and non-cash expenses, it provides a clear picture of a company’s operating performance.
• It can be used to calculate a company’s cash flow and free cash flow (the cash remaining after operating expenses and capital expenditures have been paid).
• EBITDA is a commonly recognised and widely used valuation metric that allows people to focus on baseline profitability.

Disadvantages of using EBITDA

On the minus side:

• EBITDA valuation does not take into account changes in working capital, which can have a significant impact on a company’s cash flow.
• It excludes changes in the value of assets, which can be important in some industries or sectors.
• It ignores differences in capital structures between companies, which can have a significant impact on a company’s profitability.
• While EBITDA is often used to calculate a company’s cash flow, it is not actually a measure of cash flow, because it doesn’t take into account all the factors affecting cash flow.
• It can be manipulated by companies to make their earnings look better than they actually are.

Enhancing EBITDA

When you come to sell a company, it’s in your interests to increase the EBITDA, which will boost the business valuation figure. In simple terms, this can come down to reducing costs and improving income.

Costs can be reduced as a result of, for example, cutting waste, reducing inefficiencies, better stock control, negotiating better prices from suppliers, trimming staff and restructuring. Beware of cutting costs by cutting back on maintenance and upkeep, as that can come back to bite you (or the new owner) later.

Improving income can be achieved by, for example, cross-selling and upselling to existing customers, putting prices up, running sales and marketing initiatives that focus on higher-margin products/services, increasing the range of products/services offered, introducing a gold or VIP option, and entering new markets.

Conclusion

EBITDA is a useful measure of a company’s profitability that is helpful in establishing the value of a business. Understanding EBITDA, its advantages and disadvantages, and how it compares to other valuation techniques, and metrics such as operating income and net income, can help give potential buyers a more rounded picture.

Having someone with years of experience in business mergers and acquisitions on your side can be a huge advantage. Jonathan Jay has helped more than 3,000 people buy successful businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today. To get started on your acquisitions journey, download your FREE Business Buying Toolkit now.