When Using an EBITDA Multiple Isn’t Optimal

Randy Feld

About EBITDA:  Often when we talk to clients, attorneys, or other professionals about business valuations, they want to think in terms of EBITDA multiples. It is, after all, the standard valuation metric in the M&A world, and for good reason: EBITDA (earnings before interest, taxes, depreciation and amortization) does a good job of isolating operating profitability from the effects of capital structure, tax rates/strategies, capital investment strategies, and acquisition history, all of which generally have less to do with the underlying value of operations than they do the preferences, strategies, or unique situations of individual companies or owners. For that reason, EBITDA tends to be a more useful measurement for valuation than, say, after-tax net income.

That said, it’s not a perfect metric. Like any statistic, you need to understand what it captures and what it doesn’t in order to properly use it. Below, I’ve listed 5 situations where using an EBITDA multiple to value a business is misleading or less useful than other methods:

1. The business is capital intensive

Think about a heavy construction company that uses a lot of expensive equipment. Because of its large investment in fixed assets, it will typically have high depreciation expense, which will be reflected in its net income but not in its EBITDA. This company’s depreciation expense actually represents a real operational cost (unlike, for example, a short-term spike in depreciation due to tax-incentive related purchases). As a result, this company’s EBITDA is going to be inflated relative to its actual cash flows and its EBITDA multiple is going to be lower than the average company. For capital intensive companies it usually makes more sense to compare earnings using metrics that capture the cost of the fixed assets, like EBIT (earnings before interest and taxes) or, even better, Free Cash Flows (EBITDA less capital expenditures +/- change in working capital requirements).

2. Earnings are expected to grow

A fundamental concept of valuation is that an investor pays for what’s expected to happen in the future, not what happened in the past. Imagine a company that’s making $1 million of EBITDA per year now, but expects to make $10 million 3 years from now and $25 million 5 years from now. Say that company is worth $80 million – is it useful to think in terms of an 80x multiple on this year’s EBITDA when value is really driven by the expectation for future years? In this case (and actually in most cases) a business appraiser would likely use the discounted cash flow (DCF) method to estimate value. In a DCF analysis, cash flows are forecasted out until growth stabilizes (often 5 to 10 years) and each year’s expected cash flows are discounted to present value. Additionally, the value of the business once growth stabilizes (called the terminal value) is estimated and discounted to present value also. The resulting value may bear little relationship to current EBITDA.

3. Earnings are expected to shrink

The same is true in the opposite direction. Arthur Andersen had $9 billion in revenue and presumably a very healthy EBITDA in 2001. News of the Enron scandal broke late in the year. What was Andersen was worth at year end?
This is an extreme example, but often the same idea will apply to small businesses that have lost key employees or customers and expect a subsequent decline in revenue and profits. The concept to remember is that value is determined not by past performance, but by what’s anticipated in the future.

4. EBITDA is very low or negative

If a company’s EBITDA is negative for the year, it doesn’t follow that the owner should pay someone else to take the company off his hands. In such a case, value would be estimated either by expected future cash flows (DCF method) or, in the case of a company that isn’t expected to become profitable, an asset approach whereby individual assets and liabilities are valued on a liquidation basis and then aggregated.

5. The business is a holding company or owns primarily real estate or collectibles

These entities don’t necessarily exist to produce annual cash flows. Their worth stems instead from the value of their individual assets, which can presumably be sold for cash in the future. As such, an asset approach is often more appropriate.

When, then, are EBITDA multiples most useful? The answer is when all of the below are true:

• The company is an operating business that exists to produce cash flows
• The company is established and profitable
• Growth is slow and stable
• Fixed asset expenditures are variable but low to moderate

Even when all of the above are true, it’s important to understand how to account for EBITDA adjustments like owner compensation, related-party rent, and non-recurring expenses, and how to adjust the value that the EBITDA multiple suggests for items like non-operating assets, excess working capital, and/or debt to arrive at equity value.

A valuation professional can help you sort it out and get it right. In addition to traditional independent valuation reports, at Boyum Barenscheer we offer hourly consulting services for planning purposes.  For additional information on business valuations contact Randy Feld, CPA/ABV at

*This article was written by Joe Williams, CPA, ABV


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