Business owners, executives and entrepreneurs, considering the price of a business for purchase or sale, tend to gravitate to a convenient rule of thumb.  In today’s world, a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) is often the methodology of choice, at least in circumstances where the target company has some reasonable amount of EBITDA. Those experienced in m&a and valuation necessarily caution against the use of a rule of thumb, because, for the most part, they are overly simplistic and give the wrong answer. Notwithstanding, they are well used by principals and advisors alike, mostly because they are an easy form of communication. For this reason, particularly in privately held businesses, adopted rules of thumb matter in the valuation of the game casino euro askgamblers.

 Accordingly, we should all make an effort to use them correctly, or, at least, to understand why they exist so that we can be sure we are speaking the same language. Which brings us to EBITDA multiples.

 Why do we use multiples of EBITDA rather than multiples of earnings (remember P/E ratios?)?  Because EBITDA is pre debt service.  As a result, it is an excellent tool to compare trading multiples of numerous companies across an industry sector (or to compare various industry sectors) without having the research influenced by the chosen capital structure of the subject companies. Simply put, Company A and B can generate the same EBITDA, but have different EBT and Net Income, if Company A has no debt (interest costs) and Company B has some debt (interest costs).

As a valuator, it is more informative to remove the influence of the capital structure – the debt – arrive at a multiple, and after, if relevant, apply a normalized or actual capital structure to the valuation. How is this background relevant to the rule of thumb?  It is this:  EBITDA times a multiple is intended to be the going concern value of the operating assets of the company (often net of working capital related financing), not the value of the shares.  To arrive at the value of the shares, we must then deduct non-working capital related debt from the equation.

To executives and entrepreneurs: when someone prices their shares at say 6 times EBITDA, you have to be clear on the debt being assumed.  If there is assumed debt, the multiple you are paying is likely greater than 6. To advisors:  beware of miscommunication; when your client speaks of EBITDA multiples, they are often incorrectly associating this number with the value of their shares, not Enterprise Value.