3.05: EBITDA – Earnings before interest, tax and depreciation/amortization
EBITDA (Earnings before interest, tax and depreciation/amortization) is a metric that is popular with business brokers, mergers & acquisitions advisers, and public company analysts. The theory is that EBITDA is a reasonable substitute for operational cashflows and that enterprise value can be determined by multiplying EBITDA by a suitable multiple, usually an “industry standard” multiple.
The use of EBITDA as a determinant of business value has several limitations:
- It needs to be normalised, a fact that is often lost on business owners.
- It takes no account of capital asset replacement costs, which are a regular drain on business cashflows.
- It is better suited for use in testing a valuation conclusion for reasonableness (by, for example, comparison to industry peers) than in calculating the value of the enterprise from the ground up.
- Every business has unique cost structures, so EBITDA is not necessarily a good basis for comparison between businesses in the same industry.
EBITDA is frequently used as a shortcut in determining business value: it needs to be used with care.
At MVI we prefer to use free (or discretionary) cashflow as the main determinant of operational results. Free cashflow is derived from normalized EBITDA but is adjusted for tax (on the EBITDA amount) and sustaining capital expenditures (net of their tax shield). This provides a better measure of normalized cashflow before financing costs; in calculating enterprise value, normalized free cashflow is capitalized using the weighted average after-tax cost of capital.
Contact MVI for assistance in determining the enterprise value of your company.