Written by Elliott Morrell, Manager at Claritas Tax:
Throughout the course of my tax valuations career, one of the areas that always comes up in discussion with our clients is EBITDA and the EV/EBITDA multiple used to value their company.
These discussions are usually along the lines of “why has EBITDA been used?”, “how has EBITDA been calculated?” and “is the multiple you’ve arrived at suitable for a company of our size operating in this particular industry?”
Each of these questions is considered below.
Why has EBITDA been used?
The reason EBITDA is used is because it normalises earnings for companies with different levels of debt (Interest), tax structuring and impacts (Tax) and investment decisions (Depreciation and Amortisation), making it a practical way to compare companies in an industry in order to derive an appropriate EV/EBITDA multiple.
EBITDA is also the closest proxy to cash generated from trading and assigns cash flows to the company as opposed to the company’s shareholders, a key component of valuations. This is because when an acquirer purchases a company, they are essentially purchasing the future cash flows of that company, with the expectation that what will be received in the future will be more than what they are paying for the company now.
How has EBITDA been calculated?
EBITDA, or earnings before interest, tax, deprecation and amortisation, is calculated by adding back interest, tax, depreciation and amortisation to net profit.
EBITDA must also be adjusted for exceptional or ‘non-recurring’ expenses, which refer to one-off expenses that aren’t part of a company’s day-to-day operation and therefore wouldn’t normally occur again, or occur regularly, for example redundancy costs or business restructuring costs. It can also refer to income that wouldn’t normally recur, for example the sale of a property within the company. EBITDA should also be ‘normalised’ to reflect any additional expenses that a hypothetical purchaser would need to incur. For example, where director/shareholders receive dividends instead of salaries, the EBITDA figure should be adjusted to reflect the additional salary costs that would need to be incurred by a hypothetical buyer to remunerate directors.
Other common adjustments include profits or losses on the disposal of fixed assets, gains or losses on foreign exchange, goodwill impairments and adjustments for non-commercial directors’ remuneration.
Is the multiple you’ve arrived at suitable?
The challenge with EV/EBITDA multiples is that they are based on numerous assumptions and they can easily be manipulated to suit the company requiring the valuation. However, EV/EBITDA multiples, and the use of EBITDA in general, continue to be the industry standard when considering the value of a company that generates profits (unless you’re considering the value of a software or technology company, the value of which is usually based on a multiple of revenue – being headline sales).
EV/EBITDA multiples are a tried and tested way to compare quoted companies and transactions that have occurred in the industry recently in order to value a company.
Discounts to EV/EBITDA multiples must be considered to reflect the differences between the company being valued and the comparable quoted companies and transactions that have occurred in the industry. Such differences include the size of the entity, ease of access to finance, brand power and other opportunities available to them.
Summary
Overall, EBITDA is the closet proxy to cash generated from trading, allowing a quick and easy comparison with other companies operating in the same industry and enables a suitable EV/EBITDA multiple to be calculated.
However, if not understood properly, EBITDA and EV/EBITDA multiples can be confusing and applied incorrectly, resulting in an inaccurate company valuation.
This article has been carefully prepared but has been written in general terms and should be seen as broad guidance only. The article cannot be relied upon to cover specific situations and you should not act upon the information contained therein without obtaining professional advice.
