EBITDA is a term used often in business sales, but unless you’ve sold a business before, you may not know what it means. Here we will take a closer look at the term, as 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 issues to address when using this profitability calculation. Here’s a closer look at EBITDA and how to apply it when valuing your business.
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. It is one tool that can be useful in comparing the financial strength of two or more companies.
Normalized or adjusted EBITDA means adjusted to reflect the income or expenses that would not be there going forward under a new owner. Some examples: rental income from a vacation home that would be excluded from the sale, or the owner’s salary of $1M, when fair market value for the job might be $75,000.
Divided Opinion on EBITDA
Some believe that EBITDA is a less-than-perfect business valuation metric. Irrespective of those concerns, 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.
Given that EBITDA’s usefulness in valuing a business is a subject of debate, why is it used so frequently? 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. 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.
EBITDA Ignores Many Key Factors
A key concern in considering using EBITDA in a merger or business acquisition negotiation is that is often used as a sort of substitute for “true value.” A true value does not exist for any business. EBITDA gets around some of the determining factors of the attractiveness of a particular business acquisition. 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 these historic seller’s expense amounts will not be applicable to the buyer’s new firm. It also 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, income taxes, and noncash charges that will be appropriate for the buyer, post-closing of the business sale transaction. In short, 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.
Achieving Optimal Results
In the end, EBITDA is one critical factor in the mergers and acquisitions or business sales marketplace. It is a helpful tool for assessing the market value and marketability of a business. It does not, however, account for factors that could influence the potential future growth and prosperity of a given business entity.
Professional M&A brokers, business investment bankers or others with a strong track record in selling businesses or acquisitions have a refined awareness of these factors; Mergers and acquisitions brokers are trained to fully understand the factors in business valuations to determine help analyze, set, and negotiate the sale of a business taking into account EBITDA and the myriad of other value drivers to help owners maximize the value of their business sale experience, all things considered.