EBITDA is an acronym for “Earnings Before Interest, Taxes, Depreciation and Amortization.” EBITDA can be a useful tool in comparing the financial strength of two or more companies, and it can be used as a key business valuation factor in determining your company’s market value when you are considering selling your business.
There are some important issues to address when using the EBITDA profitability calculation.
Normalized or “adjusted” EBITDA means adjusted to remove the income or expenses that would not be present under new ownership. Examples might include rental income from a vacation home that would be excluded from the sale, or the owner’s $1 million salary, when fair market value for the job might be $75,000.
Divided Opinion on EBITDA
Some business and financial professionals believe that EBITDA is a less-than-perfect business valuation metric. Their common complaint: In calculating EBITDA, one must take a complicated issue with a myriad of moving parts required to plug in and ultimately be able to compare the value of businesses.
Nonetheless, EBITDA is typically a dominant factor when buyers, sellers and M&A brokers set out to determine and negotiate business values in mergers and acquisitions. Though the calculation can be complicated, the goal is to distill the inputs to an easy-to-understand formula. In turn, the formula is designed to generate a single number.
Key Factors Ignored by EBITDA
EBITDA is valuable as an accepted measure in valuing a business, but there are important factors to consider that are omitted by its very definition.
A key concern in using EBITDA in M&A planning, marketing and negotiation is that it is often used as a substitute for true value – when in fact a “true value” does not exist for any business. One must remember that profit, the owner/seller’s discretionary earnings, EBITDA and cash flow are never the same number. All of those have uses in determining a businesses market value.
By definition and custom, the use of EBITDA omits the seller’s interest, income taxes, and non-cash charges. It does so because those seller expense amounts will generally not be applicable under the buyer’s ownership.
Also, EBITDA may not allow for necessary capital expenditures, whether to hold the status quo or to enable growth.
While EBITDA establishes a factor commonly used in business valuation discussions, a buyer will need to prepare pro forma plans to envision new levels of interest expense, income taxes, and non-cash charges that will be appropriate for the buyer after the closing.
Achieving Optimal Results
Despite its imperfections, in the M&A and business sales marketplace EBITDA is a very helpful tool for assessing a business’s market value and marketability. It does not, however, account for factors that could influence the potential future growth and prosperity of a given business entity.
Most experienced M&A brokers, investment bankers and other M&A professionals have a refined awareness of those factors, and M&A brokers are trained to fully understand how they affect business valuations and help the parties analyze, set, and negotiate the sale of a business. In the end, taking into account EBITDA and the myriad other value drivers help buyers and sellers recognize the value of the subject business en route to a successful closing and transition.