What Is EBITDA And Why Is It Used As A Valuation Metric?

by Patrick Galleher, originally published on forbes.com on March 17, 2020

There are all sorts of ways in which investors measure the financial health of a company. They’ll look at sales and cash flow. They’ll consider various assets and any outstanding debt. Beyond these traditional tools, one of the most common measurements in determining a company’s value is EBITDA.

EBITDA is an acronym that stands for “earnings before interest, taxes, depreciation and amortization.” This all sounds impressive, but how do you understand EBITDA and why it’s used as a valuation metric for your business?

I’ve worked closely with middle-market businesses in many sectors during my time as the managing partner of a middle-market investment bank. This experience has given me the knowledge necessary to pull back the curtain on EBITDA and explain how it affects the way people see their businesses.

It Helps To Measure Your Profitability

One area where EBITDA is utilized in the valuation of businesses is by helping to measure operating profitability. A company’s EBITDA is a snapshot of its net income before accounting for other factors such as interest payments, taxes or the depreciation of assets. By removing these elements from the equation, this metric provides a clearer perspective on the operational performance of a business.

After a company’s EBITDA is calculated, this number is then divided by its revenue to produce the EBITDA margin. This margin is a ratio used to illustrate a company’s operating profitability. In general, the higher the margin, the better the company looks. If a company had a margin of 15%, one could deduce that the other 85% of revenue goes toward covering a business’s operating expenses (minus amortization and depreciation).

EBITDA boils down a company’s financial information to its bare bones. Specifically, it provides a clearer understanding of operating profitability and general cash flow. This allows for an apples-to-apples comparison of profitability between two businesses.

There’s no question that EBITDA is helpful in offering better insight into a company’s finances. Still, it’s imperative to remember that this metric must always be taken with a grain of salt.

It Is Not The Same Thing As Cash Flow

I know I just talked about how EBITDA is often used to measure the cash flow of a company, and this is true. However, while it can reveal much about the financial health of a company, it’s important to keep in mind that EBITDA and cash flow are not synonymous. It’s best to think of EBITDA as an indicator of a company’s profitability that can be used as a surrogate for cash flow.

Chief among the reasons EBITDA is not the end-all-be-all as a barometer of financial well-being is right there in the name. It excludes a large number of potential expenses that have a very real effect on a business. The includes capital expenditures (capex) that add up quickly and must be considered before making an investment.

EBITDA Minus Capex Is A Vital Tool In Estimating A Company’s Value

Capex is any money a business spends to improve, maintain or buy assets such as equipment, real estate, vehicles and so on. Depending on the industry, capital expenditures can consume a significant portion of a company’s earnings. This is a big reason it is so important not to put the proverbial cart before the horse regarding EBITDA.

Let’s look at the quick-service restaurant and full-service restaurant industries. Depending on whether you are the franchisor or franchisee, these businesses can require more capital expenditures than other businesses. While inventory in restaurants is traditionally kept to a minimum, initial expenditures for land, the buildings themselves and specialty equipment are all things for investors to consider.

When a company neglects to consider capex when calculating its EBITDA multiple, it runs the risk of overestimating its available cash flow. This can present a misleading portrait of its valuation. While EBITDA is a helpful metric in getting a better idea of a business’s financial health, it’s crucial that it is considered in the larger context of a business’s finances.

It Varies Greatly From Sector To Sector

There’s no question that EBITDA is a helpful tool in evaluating a business. Even so, all EBITDA isn’t necessarily valued equally. One only has to look at the multiples of different industries to see just how wildly it can vary.

For example, if you were to consider the auto parts sector, you would see that the average multiple is 6.38 (according to numbers by the Stern School of Business at NYU). By comparison, the same research shows that the online retail sector has a multiple of 22.82. This is to say that EBITDA is best considered in the larger context of the particular industry, rather than as a whole. What may be an attractive multiple in one sector may have investors running for the hills in another.

To get a better idea of how EBITDA multiples vary from sector to sector, it’s important to note how the multiples fluctuate based on the industry itself. According to the most recent data from PitchBook, median middle-market buyout numbers in the United States are presently at almost 13x. By comparison, a similar company may have had an estimated value of closer to 8x 10 years ago. With a better understanding of these multiples, private equity firms can better deduce the return they can expect on a particular investment.

Ultimately, EBITDA remains a valuable tool for investors hoping to ascertain the equity of a business. By separating revenues from other expenses, investors can get down to brass tacks when comparing the financial wellness of different businesses. That said, it is vital to remember that this metric does not exist in a vacuum. Armed with a better understanding of EBITDA, business owners can have a better understanding of their own value in a competitive marketplace.