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EBITDA Valuation is an industry multiple or ratio method that is used commonly to determine the Enterprise Value of a company operating in the lower-middle or middle market. It differs from the method typically used by small businesses (also referred to as Main Street Businesses) in that it is not based on the Seller’s Discretionary Earnings (SDE)..
Having gained wide acceptance in the investment and banking communities, EBITDA Valuation is a measure of the company’s cash flow stream. The usefulness of calculating an EBITDA Valuation is in the assessment of a company from the perspective of an outside investor, taking into account factors such as debt and equity.
EBITDA Valuation Formula
Begin by determining your company’s EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA creates a basic picture of a company’s profitability and its ability to make payments on its outstanding debt for a given year. Such payments include interest and principal. EBITDA may be calculated as either a 12 month projection or instead from the previous 12 month’s data. And it’s not unusual for Adjusted EBITDA to be used in the computation.
Enterprise Value = EBITDA * Enterprise Multiple
To compute the Enterprise Valuation of a business, you take the EBITDA amount and multiply it by an enterprise multiple to get the total enterprise value. The enterprise multiple is dictated by the business’ industry, the cost of capital, and the overall health of business. This multiple fluctuates over time which is why it’s very important for business owners, small and large alike, to understand what the current industry multiple is and the factors which have an impact on its direction.
What Is the Enterprise Multiple?
The Enterprise multiple is a statistically derived ratio from recent comparable business sale transactions in a given industry. Additionally, while a single enterprise multiple may be sufficient for calculating Enterprise Value, more often, a range of comparable multiples – from the low end to the high end – is used to calculate a useful spectrum of possible Enterprise Values.
Enterprise multiples often vary by industry, and higher multiples should be expected in higher growth industries (like tech). Lower multiples are often expected in lower-growth industries (like railroad construction). EBITDA Valuation multiples are valuable especially in the appraisal of asset-rich industries, such as distribution, wholesale, manufacturing, real estate, and technology.
For investors and purchasers, an enterprise multiple may be used to determine whether a company is under or overvalued, as a low ratio would indicate an undervalued company while a high ratio may indicate an overvalued company.
Calculating Enterprise Value using EBITDA and an industry multiple creates a snapshot of a company’s value as a functioning business entity which incorporates its underlying debt.
How Is the EBITDA Valuation Used?
Because enterprise value includes debt, it is considered an ideal valuation method for evaluating companies for potential mergers and acquisitions. As an example, a company with a low Enterprise Value would indicate a good candidate for a merger or acquisition.
Factors to Consider When Using EBITDA Valuation Method to Value Equity
Be mindful that when using the EBITDA Valuation method to assess equity, it does not take into account important factors such as working capital and capital expenditures – both of which may possibly have a significant impact on the business’s cash flow.
I have a quick question, I am a minority shareholder in a small business and am hoping to sell my shares to the majority owners. If I am proposing EBITDA as the valuation method, lets say 4x trailing 12 months EBITDA, would I then add back in the current $1.5m cash the company is sitting on, or is that already factored into the EBITDA number? I can’t seem to find anything that address that specifically, or at least in non accounting terms I can easily understand,
I would greatly appreciate your quick thought on that question. EBITDA x multiple is the valuation number or EBITDA x multiple plus cash on hand?
When using a valuation method such as a multiple of EBITDA, the assets and liabilities on the company’s books are not considered. This does not mean assets, such as cash, are not relevant. Multiple of EBITDA valuation is a method used to determine the value of the operating business.
Where the cash and other balance sheet items come into the picture depends on the type of sale (asset vs. stock) you may be contemplating. Cash, Accounts Receivable, Accounts Payable, the Line of Credit, and other current assets and liabilities are components of a company’s Working Capital. And when valuing a business, the working capital to be transferred upon sale, should be considered.
Hope this helps you Dean! All the best…
My situation is very similar to Jonathans.
The buyer I am talking to wants to use the average of the last 3 years EBITDA. Three years ago I took out a large salary so this makes the average EBITDA much lower than the last two years.
How do I make the point that my large salary has nothing to do with the value of the business today?
I am selling my business and have calculated EBITDA as of the end of the past two years.
The income has increased a lot in the last year so the EBITDA looks much better for 2017 than 2016.
The buyer wants to use the average of the two years. I want to use the 2017 EBITDA to compute the value.
What is the correct way to handle this? Thanks!
When you are selling a business and using a multiple of EBITDA to compute and negotiate the purchase price, the most recent year is typically used or at least most heavily weighted.
At least that’s what I have observed in terms of how a buyer looks at the importance of the most recent year’s EBITDA.
If your circumstances were the opposite and your most recent year’s EBITDA were significantly less than the prior year, you can bet the buyer would be heavily discounting or ignoring altogether the higher EBITDA when negotiating the purchase price for your business.
If your EBITDA for 2017 is sustainable and you are able to show evidence this is the case, then I would argue the case to use 2017 EBITDA as the basis for your purchase price.
Hope this helps you a bit Jonathan! All the best…
I am a Business Broker and Featured Advisor for EXIT Promise. My company provides business appraisal services for business owners, banks, the courts, etc…
Typically, when EBITDA is calculated in any year for a business, an appraiser adjusts the salary to reflect the typical salary an owner would receive for that specific business in a specific industry. The reason for this is it is very common for a business owner to pay themselves a salary that is above or below the norm for an owner’s salary for a business in a specific industry.
Second, for many small businesses, EBITDA is not used to determine business value. The dollar value that is often used is Seller’s Discretionary Earnings(SDE). And, SDE includes the owner’s salary in the business value calculation.
Third, have you considered having an appraisal performed for your business by a third party expert? I often recommend my clients have their business appraised by a certified business appraiser to be able to overcome the sale price objection of the buyer who performs their own appraisal that is not based on an accepted appraisal methodology.
And finally, I almost never see a valuation where three years of EBITDA are treated equally. If averaging is used, it is typically a weighted average where the current year and previous year EBITDA values impact business value more than the EBITDA value of 3 or more years in the past.
I hope this helps. Let me know if I can be of any assistance.
Please tell me what you think about the year over year increases in the cost of Health Benefits and its effect on EBITDA.
When an operating cost in a business increases year-over-year, especially at a rate which exceeds the rate of growth in gross revenue and gross profit margin, EBITDA erodes.
Over time, this situation is unsustainable for businesses and will mean its owners will have to reduce operating costs in some other way.
If costs are not reduced, EBITDA will decline and the value of the business declines as well.