EBITDA:  Why is it used to value a business?

EBITDA, or earnings before interest, taxes, depreciation, and amortisation, is a measure of a company’s financial performance that is commonly used in the valuation of businesses. In this article, Director Andrew Steen explains what EBITDA is, why it is used to calculate the value of a business, and considers the advantages and disadvantages of using EBITDA as a valuation metric.

What is EBITDA?

EBITDA measures a company’s profitability by considering its operating earnings before certain non-cash expenses and non-operating items. These non-cash expenses and non-operating items are:

• Interest – the cost of borrowing money
• Taxes – the amount of taxes a company pays on its earnings
• Depreciation – the decrease in value of tangible assets over time
• Amortisation – the decrease in value of intangible assets over time

By excluding these items from the calculation, EBITDA provides a clearer picture of a company’s operating performance and cash flow, as it removes the effects of non-recurring or non-operating expenses.

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

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

Why is EBITDA used to calculate the value of a business?

EBITDA is a commonly used valuation metric because it provides a clear, consistent picture of a company’s operating performance over time, regardless of changes in interest rates, tax rates, or depreciation methods, making it easier to compare companies within the same industry or sector. EBITDA is often used in the valuation of private companies, as they may not have the same level of transparency as public companies whose financial performance metrics are widely published.

When valuing a business, the goal is to determine how much it is worth in terms of cash flow, assets, and market position. EBITDA is used as a starting point for this valuation because it represents a company’s earnings before non-cash expenses and non-operating items are considered.

EBITDA can also be used to calculate a company’s cash flow, which is important in determining the amount of debt a company can take on, as well as its ability to pay dividends to shareholders. Cash flow is calculated by subtracting capital expenditures (the amount a company spends on long-term assets like property and equipment) from EBITDA. The resulting number is called ‘free cash flow’, which is the amount of cash a company has available for distribution to its stakeholders.

Finally, EBITDA is a useful metric for identifying potential acquisition targets, as it provides a quick and easy way to determine a company’s financial operating performance and cash flow. By using EBITDA as a starting point, investors can quickly identify companies that may be undervalued or overlooked by the market.

What are the advantages and disadvantages of using EBITDA as a valuation metric?

While EBITDA is a commonly used valuation metric, it does have its advantages and disadvantages.

Advantages:

• It is commonly recognised as a preferred valuation metric
• Provides a clear picture of a company’s operating performance by excluding non-cash expenses and non-operating items
• Allows for easy comparison of companies within the same industry
• Can be used to calculate a company’s cash flow and free cash flow
• Provides a quick and easy way to identify potential acquisition targets

Disadvantages:

• Lack of consideration for changes in working capital:  EBITDA does not take into account changes in working capital, which can have a significant impact on a company’s cash flow. For example, if a company has to invest heavily in inventory to meet demand, it may have a negative impact on its cash flow, even if its EBITDA is strong.
• Misleading picture of a company’s financial health: EBITDA can be manipulated by companies to make their earnings look better than they actually are. For example, a company may cut back on essential maintenance expenses to increase its EBITDA, but this could lead to long-term problems down the road.
• Does not account for differences in capital structures: EBITDA does not account for differences in capital structures between companies, which can have a significant impact on a company’s profitability. For example, a highly leveraged company may have a higher EBITDA than a company with a lower debt-to-equity ratio, even if the latter is more financially stable.
• Ignores changes in the value of assets: EBITDA does not take into account changes in the value of assets, which can be important in certain industries. For example, in the technology industry, a company’s intellectual property may be its most valuable asset, but EBITDA does not account for the value of intangible assets.
• Not a measure of cash flow: While EBITDA is often used to calculate a company’s cash flow, it is not actually a measure of cash flow. EBITDA only takes into account earnings before non-cash expenses and non-operating items are taken into account, but cash flow is affected by a wide range of factors, including changes in working capital, capital expenditures, and other non-operating items.

Overall, while EBITDA can be a useful starting point for valuing a business, it is important to keep in mind its limitations and to consider a wide range of other factors when determining a company’s true value. Other metrics, such as untapped future potential, free cash flow, operating cash flow, and net income, may provide a more comprehensive picture of a company’s financial health and future prospects.