In the world of mergers and acquisitions, it is commonplace to hear business owners and their advisors reference a transaction price or value based on a multiple of EBITDA (i.e., earnings before interest, taxes, depreciation and amortization). While multiples of EBITDA can sometimes provide a useful reference point, here are the top 5 reasons why multiples of EBITDA may be dangerous.
1. What Time Period for EBITDA?
If a company’s performance has varied in recent years, the time period for which EBITDA is calculated could significantly influence the implied multiple. Consider a company that produced EBITDA of $100 last year, has an EBITDA run-rate of $70 this year and is expected to produce EBITDA of $130 next year. A 5x multiple would suggest values ranging from $350 to $650 – quite a wide range. So what EBITDA should you use? The proper EBITDA would be a current “normalized” level of EBITDA (which can require significant analysis to ascertain).
2. Normalization Adjustments in EBITDA.
Oftentimes, a company’s reported EBITDA may not reflect its true operating performance. It is often appropriate to “normalize” EBITDA due to unusual, non-recurring or discretionary income, or expense items that a potential buyer would not be likely to incur. These normalization adjustments can have a material impact on an implied multiple of EBITDA.
3. CAPEX, Depreciation and Working Capital.
While EBITDA often serves as a proxy for net cash flow, it is important to remember that EBITDA is not equal to net cash flow. Capital expenditures (“CAPEX”) reduce a company’s net cash flow, but are not factored into an EBITDA calculation since CAPEX does not hit the P&L. Also, as companies grow, they typically require investments in higher levels of receivables, inventories and other working capital assets to support higher revenue levels. These investments are a use of future cash, but are not reflected in EBITDA.
A company’s valuation is, in large part, a function of its expected growth in cash flow. Growth cannot be captured in a static EBITDA calculation.
5. Where Does the Multiple Come From?
Oftentimes, multiples are just assumed based on the expectations and experience of business owners and their advisors. While it is commonplace to hear about multiples of 5x or 6x, there are many industries where EBITDA multiples can be much higher or lower. Also, company-specific factors should influence the selection of an EBITDA multiple. In short, assessing the proper multiple of EBITDA requires in-depth analysis of a company and its industry.
The value of any company (or any investment, for that matter) is equal to the present value of all future cash flows to be generated from that company. While an EBITDA multiple may assist in developing a proxy for value, this should be done (a) only after careful analysis of the factors above, and (b) only when supplemented with a comprehensive discounted cash flow analysis, which can reflect a company’s projected growth in revenues, profits and cash flows.
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