How are EBITDA multiples used to value companies?
An introduction to EBITDA multiples – what are they, and how can they be used to value a business?
Corporate finance advisers, private equity firms and corporate acquirers often value privately-owned businesses using ‘EBITDA multiples’.
EBITDA is a measure of profit that is intended to reflect the trading performance of the business. In its simplest form, it is calculated by taking operating profit and adjusting the figure to strip out common non-trading items and accounting adjustments. The full acronym stands for Earnings Before Interest, Tax, Depreciation and Amortisation. Interest and tax payments do not relate to trading, whilst depreciation and amortisation are not cash expenses. Because it adjusts for these items, EBITDA therefore roughly equate to a measure of operating cash flow.
But how can EBITDA be used to value a business?
One common method is to look at ‘comparable transactions’. This involves estimating the likely market value of a company by looking at the sale prices achieved by similar companies in recent transactions. At the simplest level, imagine that Company A had EBITDA of £20m and was recently sold for £100m – a 5x multiple of EBITDA. Assuming that Company X, which has EBITDA of £5m, is sufficiently similar to Company A, it might be reasonable to argue that it is worth £25m, by applying the same EBITDA multiple. In the course of negotiating a deal, the buyer and seller are likely to debate whether the 5x multiple is really appropriate. But it can serve as a useful starting point for the discussion.
EBITDA multiples can vary significantly across industries. Looking at transactions in the UK over the past 20 years reveals that most businesses sell at a multiple between 4x and 8x EBITDA. But higher and lower multiples are possible.
Further adjustments to EBITDA
If a company is going to be valued according to its EBITDA, then of course it is important to make sure that the figure used is a fair reflection of the business’s real performance. It is often sensible to make some further changes to the EBITDA figure, producing a figure referred to as ‘adjusted EBITDA’.
One common adjustment is to strip out the owner’s remuneration and benefits (including salaries, bonuses, company cars, pension contributions) and add a figure based on an assumption about the market rate for a chief executive. The reason for this adjustment is that the way owner-managers reward themselves can distort the EBITDA figure. Their total compensation could be above the market rate. Or they may pay themselves a small salary because they draw significant dividends. Either way, it is reasonable to adjust the EBITDA to reflect what the performance would be if the company was run by directors paid at the market rate.
It is also important to look for exceptional costs or income that affect EBITDA. If there are significant costs or revenues that would not be expected to recur in future years, they should also be stripped out of the adjusted EBITDA figure.
A note of caution
Using EBITDA multiples to value a business has the advantage of simplicity. It provides a framework within which buyers and sellers can agree raw, objective data for the calculation of EBITDA, then negotiate an appropriate multiple.
However, whilst adjusting EBITDA as described above is reasonable, it can also muddy the waters. Publicly available information about comparable transactions may not reflect the adjusted EBITDA figure that was privately calculated during negotiations. Furthermore, journalists may dig out EBITDA figures from accounts filed at Companies House, whereas the deal negotiations are more likely to have focused on the latest available information from the company’s management accounts. As such, publicly available EBITDA multiple information needs to be taken with a pinch of salt.
Valuing your business
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