This is the introductory post of my thread on increasing EBITDA and business value. It comes after my first post because it was more fun to write first about some things to do and then return to, as one of my clients refers to my way of thinking, the academic issues. So here I define EBITDA, why it’s important and how it affects the investment value of your business.
EBITDA, is an acronym for Earnings (profit) Before Interest, Taxes, Depreciation, and Amortization. It is essentially, net profit with interest, taxes, depreciation and amortization added back. It is used by buyers of businesses to help determine what they should pay for the business because it eliminates taxes and interest, which for this purpose are considered outside the control of management and it nets out depreciation and amortization which are non-cash items that do not directly affect the cash returns of the business to its owners.
The formula for business value is:
EBITDA X MULTIPLE = VALUE
The multiple in the formula is a factor that investors use to express the expectations of future returns for the business. They vary by industry and by risk factors specific to individual companies. For example, in general, companies that make software for sale, and other technologies for that matter, enjoy higher multiples than those in the transportation sector like trucking companies. This reflects the market expectation that a software company will become more profitable over time as it sells the same code to a larger customer base while the trucking company’s profit margin will remain the same as it grows because it must add trucks and drivers to serve a growing number of customers.
In a nut shell, EBITDA reflects the financial strength of a business in the recent past, and the multiple reflects investor’s expectations regarding the financial strength of the business going forward.
EBITDA is affected by the amount of sales the business generates and by the expenses it incurs.
The multiple is affected by risks that the business takes deliberately or faces due to the industry and markets in which it operates, and management’s decisions. For example, a business that has three year contracts for recurring business is a less risky business than one that must go out and find each new sale and has no ongoing customer relationships. The former is more predictable and the latter less so. All things being equal, with the same EBITDA, the former business will have a higher multiple than the latter.
“So how should I increase my business value?” I hear you asking.
My answer is simple and complex at the same time. Increase EBITDA by increasing profitability first and raising sales second. Increase your multiple by reducing risk, thereby increasing control.
These things can be done in concert and the impact in just a single year of this kind of focused effort almost can’t fail but to yield $1 million or more in the investment value of a business.