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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.