The value of a business is ultimately determined by what a willing seller and buyer agree upon. While there are no absolute rules, there are conventional practices for valuing a business that informed buyers and sellers generally follow. One of those is valuing a business as a multiple of its net annual profit expressed in a form called EBITDA.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To calculate it, analysts start with the profit shown on an income statement and add back interest, tax, depreciation and amortization expenses.
EBITDA vs. conventional profit
When we typically think of profit, we think of the difference between sales and expenses shown as net profit on the bottom line of an income statement. However, this conventional measure may not accurately represent a business’s profit potential and has generally been replaced by EBITDA for valuation purposes.
Why add back interest, taxes, depreciation and amortization?
EBITDA helps analysts evaluate the profit potential based on core activities by disregarding some of the current owner’s financial and accounting decisions.
To see how an owner’s financial and accounting decisions can affect profitability, consider two “identical” businesses run by different owners:
One owner is cash-poor and has to borrow heavily, incurring significant interest expenses.
The other owner is cash-rich, borrows no money and pays no interest expenses.
Although we defined the two example businesses as identical, the cash-poor owner’s business will be less profitable because of the high interest expenses. EBITDA eliminates interest as a factor and allows an apples-to-apples comparison.
The same logic applies to taxes, depreciation and amortization, which all depend heavily on the owner’s financial and accounting decisions rather than the business’s core operations. By adding back these expenses, EBITDA makes it possible for both buyers and sellers to evaluate the profit potential of a business independent of the owner.
Historical context of EBITDA
EBITDA became a popular metric in the 1980s, primarily in the context of leveraged buyouts. Financial analysts needed a way to evaluate companies’ operational performance without the distortions caused by different capital structures. This need led to the widespread adoption of EBITDA.
In the decades since, EBITDA has become a standard measure used to value companies by helping investors and business owners alike gain a clearer picture of a company’s operational efficiency.
Criticisms and limitations
Despite its advantages, EBITDA is not without its critics. For example, Charlie Munger, Warren Buffet’s former business partner, argued that excluded expenses are real costs and that a realistic look at a business should include the actual expenses incurred.
EBITDA can be misleading, as it excludes important costs that impact a company’s profitability and cash flow. For example, companies with high debt levels may appear more profitable than they actually are when evaluated solely on EBITDA because debt itself is not a factor in EBITDA while interest and depreciation expenses are excluded.
See also
EBITDA can also be “engineered” — like when a business owner, anticipating a sale, makes decisions intended to maximize EBITDA rather than operating profit. This might happen, for example, when a company borrows money to buy equipment rather than leasing it. Borrowing money could result in a higher EBITDA, and therefore a higher value, because depreciation and interest expenses would not reduce EBITDA profit, while leasing expenses would. There is nothing wrong with engineering EBITDA, but there are occasions when maximizing it may not maximize conventional net profit. This could happen in our example above if total borrowing costs were higher than total leasing costs.
Critics also point out that EBITDA does not account for changes in working capital or capital expenditures, which can have a significant impact on businesses. As such, it is important for analysts to consider these factors when using EBITDA as a valuation tool. Nevertheless, EBITDA is widely used in business valuation, and any business owner who contemplates selling should know how it is calculated and used.
Comparison with other metrics
While EBITDA is a valuable metric, it should be used alongside other financial measures to provide a comprehensive view of a business’s performance. Net profit, gross profit and free cash flow are also important metrics that offer different perspectives on a company’s financial health.
For example:
- Net profit: Includes all expenses, providing a complete picture of profitability after accounting for interest, taxes, depreciation and amortization.
- Gross profit: Focuses on the profitability of core business activities by subtracting the cost of goods sold from revenue.
- Free cash flow: Measures the cash generated by the business that is available for distribution to shareholders, reinvestment or debt repayment.
Understanding EBITDA is important for accurately assessing the true profit potential of a business. Unlike conventional profit, EBITDA provides a clearer picture of operating efficiency by excluding owner-specific financial and accounting decisions. This makes it an important metric for both buyers and sellers in the business valuation process.
In the next issue, I will show how businesses are valued by multiplying EBITDA by a second number known as “the Multiple.” I will also discuss how having good books can dramatically affect the value of your business and how business owners who understand EBITDA and the Multiple — and who plan for an exit in advance — can significantly increase the value of their businesses.
