How to Evaluate a Business with EBITDA
One of the most common measurements in determining a company’s value is EBITDA. It’s an acronym that stands for “earnings before interest, taxes, depreciation and amortization.”
A company’s EBITDA is a snapshot of its net income before accounting for other factors such as interest payments, taxes or the depreciation of assets. By removing these elements from the equation, this metric provides a clearer perspective on the operational performance of a business.
After a company’s EBITDA is calculated, this number is then divided by its revenue to produce the EBITDA margin. This margin is a ratio used to illustrate a company’s operating profitability. In general, the higher the margin, the better the company looks. If a company had a margin of 15%, one could deduce that the other 85% of revenue goes toward covering a business’s operating expenses (minus amortization and depreciation).
What is an EBITDA margin?
The Higher The EBITDA Margin The Better
One accounting method to calculate a more realistic profit picture for a company is an EBITDA margin. To determine your business’s EBITDA margin, you must first calculate its EBITDA and then divide that number by total revenue:
EBITDA margin = EBITDA / Total revenue
For example, let’s say company A has an EBITDA of $500,000 along with a total revenue of $5 million.
$500,000 ÷ $5,000,000 = 10%
The total EBITDA margin will be around 10%.
The EBITDA margin shows how much operating expenses are eating into a company’s gross profit. In the end, the higher the EBITDA margin, the less risky a company is considered financially.
EBITDA is often most useful for comparing two similar businesses or trying to determine a company’s cash flow potential. EBITDA is also a handy tool for normalizing a company’s results so you can more easily evaluate the business. To be clear, EBITDA is not a substitute for other metrics such as net income. After all, the items excluded from EBITDA — interest, taxes, and non-cash expenses — are still real items with financial implications that should not be dismissed or ignored.
An example of an EBITDA Calculation
EBITDA equals net income plus interest, taxes, depreciation and amortization expense. Here is an example:
Let’s say company A has the following financial info:
Net income – $1.8 million
Interest paid – $260,000
Depreciation – $180,300
Taxes paid – $132,500
If you’re starting your EBITDA calculation with your net income instead of revenue, you would use this formula:
EBITDA = Net income + Taxes + Depreciation + Amortization + Interest
$1.8 million + 132,500 + 180,300 + 260,000
The EBITDA would be $2,372,800.
EBITDA – Past and Present
Measuring a company by EBITDA first became popular in the 1980s at the height of the leveraged buyouts era. During this time, it was common for investors to financially restructure distressed companies, and EBITDA was primarily used as a yardstick of whether a business could afford to pay back the interest associated with restructuring.
Today, EBITDA is commonly used by bankers to determine your debt service coverage ratio (DSCR). This is a type of debt-to-income ratio, used specifically for business loans, that is meant to measure your cash flow and ability to pay.
“When lenders assess the risk of their loan portfolio, they break losses into two components: the probability of default and the severity of default,” said Rob Stephens, CPA and founder of CFO Perspective. “This ratio measures the probability of default, which is how likely [it is that] the borrower will not be able to meet their contractual debt service obligations.
EBITDA Minus Capex Is A Vital Tool In Estimating A Company’s Value
Capex is any money a business spends to improve, maintain or buy assets such as equipment, real estate, vehicles and so on. Depending on the industry, capital expenditures can consume a significant portion of a company’s earnings. This is a big reason it is so important not to put the proverbial cart before the horse regarding EBITDA.
Let’s look at the quick-service restaurant and full-service restaurant industries. Depending on whether you are the franchisor or franchisee, these businesses can require more capital expenditures than other businesses. While inventory in restaurants is traditionally kept to a minimum, initial expenditures for land, the buildings themselves and specialty equipment are all things for investors to consider.
When a company neglects to consider capex when calculating its EBITDA multiple, it runs the risk of overestimating its available cash flow. This can present a misleading portrait of its valuation. While EBITDA is a helpful metric in getting a better idea of a business’s financial health, it’s crucial that it is considered in the larger context of a business’s finances.
What is a good EBITDA?
An EBITDA over 10 is considered good. Over the last several years, the EBITA has ranged between 11 and 14 for the S&P 500. You may also look at other businesses in your industry and their reported EBITDA as a way to see how you measuring up.
It Varies Greatly From Sector To Sector
For example, if you were to consider the auto parts sector, you would see that the average multiple is 6.38 (according to numbers by the Stern School of Business at NYU). By comparison, the same research shows that the online retail sector has a multiple of 22.82. This is to say that EBITDA is best considered in the larger context of the particular industry, rather than as a whole. What may be an attractive multiple in one sector may have investors running for the hills in another.
To get a better idea of how EBITDA multiples vary from sector to sector, it’s important to note how the multiples fluctuate based on the industry itself. According to the most recent data from PitchBook, median middle-market buyout numbers in the United States are presently at almost 13x. By comparison, a similar company may have had an estimated value of closer to 8x 10 years ago. With a better understanding of these multiples, private equity firms can better deduce the return they can expect on a particular investment.
Arguments against EBITDA
While many find EBITDA to be a good indicator of performance, others believe the calculations can be quite deceptive and not representative of a company’s profitability. Like any tool, EBITDA can be used for good or ill, so it is largely up to the observer to draw their own conclusions. However, there are some long-standing criticisms of EBITDA.
The main argument against relying on an EBITDA calculation as a performance indicator is that it does not account for changes in working capital. This indication of the company’s liquidity fluctuates along with interest, taxes and capital expenditures. While a negative EBITDA value does tend to indicate that the business has trouble with profitability, a positive value is not necessarily synonymous with a healthy company, because taxes and interest are actual expenses that businesses must account for. In contrast, a company may have low liquidity if its assets are difficult to convert into cash but maintain a high level of profitability.
EBITDA can also provide a distorted picture of how much money a company has available to pay off interest. When you add back depreciation and amortization, a company’s earnings can appear greater than they really are. EBITDA can also be manipulated by changing depreciation schedules to inflate a company’s profit projections.
The reason why a company is relying on EBITDA is an important indicator as to whether it’s using the formula in good faith. Startups, especially those that require heavy upfront investment to realize future growth, are likely to use EBITDA for good reasons. It is also effective for comparing a business against competitors, industry trends and macroeconomic trends. If a struggling business suddenly starts relying on EBITDA when it never has before, however, the formula is likely not being used appropriately.
The most important question for investors and analysts is to ensure that the company’s financials have been recently and thoroughly audited by a CPA.