Applying a multiple to EBITDA is often the default methodology for business owners and advisors to estimate the value of a business.  However, the EBITDA approach to value is often misunderstood and incorrectly used, leading to bad valuations that can negatively impact M&A discussions, restructurings or similar transactions.

One example of a complication with the EBITDA approach is that the resulting calculation is an estimate of Enterprise Value, not shareholder value.  To arrive at the value of the shares of the company, you have to deduct interest bearing debt (but not necessarily all interest bearing debt).

See HERE and HERE for more on the pre-debt service nature of EBITDA and Enterprise Value.

Another trick to understanding the EBITDA approach, or specifically its limitations, is remembering that the methodology inherently assumes that the EBITDA of the business is maintainable at a constant level until the end of time (referred to as “maintainable EBITDA”).  The methodology accommodates EBITDA growth within the multiple (that is, all things being equal, the difference between a 4x multiple and a 7x multiple is likely the growth assumption).  Similar to the maintainable EBITDA assumption, the methodology assumes that the rate of growth is also constant until the end of time.

The basis of any valuation is the discounting of future cash for time and risk.  In other words, the true methodology to value everything is a discounted cash flow (DCF) model.

Other methodologies, such as EBITDA multiples, are used as a short cut to a DCF because most can’t do a DCF model in their head or they feel that the detailed inputs required in a DCF model, such as the financial projections, are not credible.  The EBITDA approach is also used because it can provide a quick and easy comparison between certain similar businesses.

But if your business is early stage, high growth, troubled, restructuring, dependent on assets with limited life or for any other reason unable to reasonably project a constant and stable EBITDA, an EBITDA valuation methodology will likely result in an unsatisfactory result.

In these instances, a DCF approach (or, in certain circumstances, an asset based approach) should be considered.

Posted by Scott Sinclair, Range Advisors

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