The EBITDA Multiple is the most common method venture capitalists, and financial analysts use to value businesses as investment opportunities.
If we plan to acquire a company or sell our own, EBITDA can be a great starting point for measuring the potential value in a sale.
When we enter negotiations to sell or purchase a business, it’s common to perform a due diligence process. The acquiring party will aim to reason a lower valuation by adjusting EBITDA down. On the other hand, the seller will try to justify as many add-backs to EBITDA as possible. They will aim to show better profitability and ultimately raise the valuation of the business. Well-prepared financial statements support a thorough due diligence process and assure proper valuation of the company.
This levels the playing field and ensures we base negotiations on the correct figures.
When a company shows significant growth consistently over the review period, then the acquisition proposal may include a sizeable purchase premium to incentivize the selling party.
However, if the company and the prospective buyer cannot agree on the purchase price, they face a ‘valuation gap.’ More often than not, entrepreneurs have an unrealistic idea of how much their business is worth. This can be very different than what the buyer is valuing the company at.
Therefore, it’s usually better to hire a professional valuation expert to determine the business’s fair value. As mentioned above, the final price may differ from the fair value defined in the due diligence process. There may be a premium if the buyer wants to compete with other bids or puts additional intangible value on the business, like potential synergies.
What is the EBITDA Multiple
The metric is a financial ratio that compares a company’s Enterprise Value to its annual EBITDA. We use it to determine the value of a company and compare it to others.
The metric provides a normalized ratio to compare various companies regardless of differences in capital structure, applicable tax, property, plant & equipment, and others.
The multiple considers both debt and equity, giving a better representation of the overall business performance.
When we know the EV and EBITDA for a particular company, its multiple shows us how many times EBITDA we have to pay to acquire the business theoretically.
Enterprise Value shows the company’s total value, and EBITDA measures its overall financial performance.
Enterprise Value (EV)
EV is the total value of the company, the sum of all financial claims against the business. It represents the theoretical takeover price in M&A transactions, not considering the acquisition premium.
We calculate Enterprise Value by adding the market cap of all the company’s outstanding shares, the total debt, any preferred shares or non-controlling interests, and then subtracting the balance of cash and cash equivalents.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA shows the company’s profitability before non-operating and non-controllable items. When we calculate the metric, it is essential to take the depreciation and amortizations from the cash flow statement.
We calculate EBITDA by starting from Net Income and then adding back Taxes, Interest, Depreciation, and Amortization. We should also consider any additional adjustments like one-off income or expense items and others.
We often use EBITDA to represent cash flow, although it’s not equally applicable across various industries.
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EBITDA Multiple Uses in Financial Analysis
The metric is widely prevalent among financial analysts as it has many applications. We cannot only determine the multiple at which a company’s stock is currently trading, but we can also compare the valuation of multiple companies.
The EBITDA multiple is an essential part of the Terminal Value calculation when preparing a Discounted Cash Flow (DCF) model. It can also help us calculate the target company price as part of our equity research, and it’s instrumental when we negotiate the acquisition of a private company.
When we compare companies by EBITDA Multiple, we have to ensure we use the same period metric. There is also a difference between using historical vs. forecasted EBITDA. Most businesses budget their future performance from a highly optimistic standpoint. Forward-looking financial models usually show improved margins. Therefore, we use lower multiples when valuing based on forecasted EBITDA.
Different companies tend to have varying multiples. Publicly traded businesses usually have larger EBITDA multiples than privately held ones.
Multiples are suitable for the valuation of asset-rich companies in manufacturing, real estate, wholesale, transportation, and others.
A higher potential for future growth will usually translate into a higher EBITDA Multiple. More established companies with a larger footprint will also have a higher multiple, as larger enterprises tend to have less risk.
All of the above will impact the EBITDA Multiple we will use for our valuation purposes.
Business Valuation with the EBITDA Multiple
Using EBITDA and an EBITDA Multiple is the most common valuation approach when looking to acquire a privately held company. Multiples vary between industries, and we need to consider other factors that may influence the valuation (Intellectual Property, location of the business, and others).
We usually look at recent transactions with similar companies and what EBITDA multiples they sold at. Taking an average of those, we can apply this to the target’s EBITDA and arrive at a valuation for the company (Enterprise Value).
Advantages and Disadvantages
As with any metric in finance and economics, using the EBITDA Multiple has specific benefits and drawbacks. Whenever we rely on the ratio to compare companies, we need to consider the inherent pros and cons.
- The multiple is easy to calculate for public companies, where the information is readily available;
- It’s popular in the financial community;
- Works very well for valuing mature businesses with low capital expenditure requirements;
- It’s good when we compare companies of different sizes;
- Using an EBITDA multiple provides for a faster valuation than some alternative methods like an income analysis.
- The EBITDA we use may not be a good enough representation of cash flows;
- If the company has significant capital expenditures, the EBITDA multiple will not consider them;
- It is hard to adjust the metrics for varying growth rates.
The primary issue with the valuation method is that multiples for comparative businesses are, at best, an approximation. The target company is different from them in one or another way.
Also, there’s no regulation in terms of how to calculate EBITDA. It is not officially defined, which leaves the opportunity for companies and business managers to misrepresent the metric.
Example Business Valuation with EBITDA Multiple
We are looking to purchase a majority stake (75%) in a manufacturing business, focusing on car parts. The first thing we do is get their financials over the last few years and normalize those.
Whether we do this internally or hire an external consulting firm, the crucial part is to get the potential seller to agree with the normalized numbers.
Here are the Income Statement and the Balance Sheet over the last three years.
We will use these numbers to create a simple valuation model for the potential business acquisition. To value the company, we need the Enterprise Value. As it’s not a public company, we need to estimate this value.
Googling the average Automobile Parts EBITDA multiples, we get results ranging anywhere between 7.0x and 10.0x. As those are for larger and more stable companies, we will build our offer on a 6.5x multiple.
When we multiply the normalized EBITDA by the selected multiple, we arrive at the business’s Enterprise Value at €342 mil. This represents the overall value of the company. The next step is to deduct the net debt or total debt less cash and cash equivalents. What we get after this is the Equity Value of the business.
The Equity Value represents the fair purchase price for the business. As we are looking to acquire a 75% stake in the company, we can easily calculate the consideration reflecting that equity stake.
To be competitive against other bids, we may also want to add a purchase premium to our offer. We are adding €10 mil on top of the consideration, or around 5%.
Once we have the Total Consideration, we can break it down into Cash and Equity if we plan to cover some of the offered consideration by giving the seller a stake in the acquiring business.
We end up offering a total consideration of €211 mil for a 75% stake in the business. We propose to split this to €81 mil in cash and €130 mil in equity.
The EBITDA Multiple is a popular valuation tool that helps investors compare investment opportunities. It’s best to use it when we benchmark businesses within the same industry.
The metric offers an easy way to estimate the fair value and is a crucial part of a financial analyst’s toolbox. The EBITDA Multiple is a standard valuation method in M&A whenever we look to acquire privately held companies.
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