Valuation considerations: EBITDA

Anyone with a basic exposure to the world of business valuation and corporate finance transactions,  will have at some point come across the term EBITDA.  You can pick virtually any M&A announcement across any sector, and find the mention of EBITDA as an underlying performance and valuation metric.

What is EBITDA and why is it used?

Despite not being officially recognised under any accounting standard, EBITDA (an acronym for earnings before interest, tax, depreciation and amortisation) is one of the most widely used terms in corporate finance transactions.

EBITDA should also include adjustments to normalise one off income and costs, and include an appropriate director’s remuneration for the business. Such adjustments can be very subjective, and the subject of much debate in a corporate finance transaction!

The EBITDA is combined with a valuation multiple to provide the Enterprise valuation of the Company i.e.  the valuation before adjustment for net cash/debt, and working capital.

By stripping away non-operational expenses and non-cash items such as depreciation, EBITDA in theory allows for a cleaner analysis of the underlying profitability, and a proxy for the operating cash flows of a Company. It is a measure free from the impact of accounting policies, capital structure and taxation regimes.

Limitations of EBITDA

Given its extensive use , it may come as a surprise that EBITDA has several important critics, one of the most stinging coming from Warren Buffett who is credited with having said “does management think the tooth fairy pays for capital expenditure”.

Most of the arguments against using EBITDA come down to the question of whether excluding interest, tax, depreciation and amortisation, really provides a more accurate picture of the operating performance of a Company. The following are some of the reasons why this might not be the case.

For companies in capital intensive sectors such as manufacturing or transport, depreciation is a major P&L cost and cannot be ignored. Depreciation is a very real cost, it is the cost of consuming productive capacity.

In such businesses, EBIT (earnings before interest and taxation) would be a more appropriate measure, this is because EBIT takes depreciation into account.

Similarly does excluding interest provide a more accurate reflection of operating performance, when even the smallest of companies will tend to have some form of debt finance in the business, and this can represent a sizeable proportion of overheads.

Critics of EBITDA also point out that by excluding working capital factors, EBITDA is not the indicator of operating cash flow that it purports to be. For example two businesses with the same EBITDA could have very different cash flows due to differences in debtor days, stockholding requirements etc.

Given the above why is EBITDA used

One of the key reasons EBITDA is so commonly applied is because of its ease of calculation and comparability compared to alternatives.

For example other valuation methodologies such as the discounted cash flow valuation would involve forward projections significantly beyond the resources of many businesses.

Therefore EBITDA whilst having limitations is likely to continue to be a key metric in Corporate Finance transactions. However it is vital that business owners take appropriate advice to ensure that benchmarks such as EBITDA are applied in an appropriate context.

If you would like to discuss further, please contact Ian Waddingham from the Corporate Finance team on 01772 821021