#EBITDA article series
Company valuation is one thing that every entrepreneur must bear in mind at every stage of a business. No significant decision can be taken without estimating the market value of a company at any given point. Factors called valuation multiples are important indicators in this process. Investors and company managements alike use these valuation multiples by industry as a guide in funding and budgeting decisions. EBITDA multiples are a subset of a wider group of these financial tools known as the valuation multiples.
In this article, we focus on this particular category of valuation multiples and discuss their pros and cons, as well as their applicability in various industries.
‘Multiple’ as such means a factor of one value to another. In the context of company valuation, valuation multiples represent one finance metric as a ratio of another. These multiples are widely categorized into three types – equity multiples, enterprise value multiples, and revenue multiples. This article focuses on EBITDA multiples valuation which is a type of enterprise value multiple.
What is EBITDA Multiple?
EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. EBITDA multiples are a ratio of the Enterprise Value of a company to its EBITDA. These multiples are very useful to estimate the market value of a company based on a set of standard factors and simultaneously compare them to other companies in the industry with similar credentials. They are especially beneficial to compare companies within the industry but vary in aspects such as their capital structure, asset ownership, taxation, etc.
Usually in the initial stages of a business, revenue multiples are used. As the company begins to mature and profit potential becomes a determining factor for investors and market valuation, EBITDA multiples by industry are used to understand the profit potential of a company. A higher value indicates a higher profit possibility and vice versa. However, as a good practice, these multiples are not used as a single point of reference. Experienced analysts always refer to the value from two or more valuation multiples to arrive at a realistic valuation of a business.
Why is the EBITDA Multiple important?
To understand the importance of EBITDA multiples, one must begin by questioning the relevance of the two factors used in the calculation – the EV (enterprise value) and the EBITDA of the company. Enterprise value estimates the total worth of a company in the market, while EBITDA measures the profit potential of the same business. When these two are calculated as a factor of one to another, the resulting multiple provides a realistic estimate of the true merit of the company as an investment option. Investors can compare the multiples of various companies and estimate how much they really need to pay to acquire this company.
As a practice, it is seen that the lower the value of the EBITDA multiplies by industry, the cheaper is the acquisition cost of the company. Usually, any value below 10 is considered good. Thus with an EBITDA multiple, investors planning on the acquisition can estimate the following:
- Company A is trading for example at 5x
- Company B, C, D, and E are trading at 7x, 6.5x, 3x, and 9x respectively
- Company D with an EBITDA multiple of 3x seems to be the best choice for acquisition
Investors find EBITDA multiples valuation reliable while considering companies within the same industry for mergers and acquisitions. However, it is important to know that investors will always try to pitch for a lower valuation and make the necessary adjustments to the EBITDA multiple while a seller will try the opposite. An expert analyst should always keep a lookout for wrong estimations arising from these factors.
EBITDA Multiple formula
As discussed, EBITDA multiple by industry is derived from two financial metrics – the enterprise value and the EBITDA of a company. The formula looks like this:
EBITDA multiple = Enterprise value (EV) / EBITDA multiple
Let’s discuss each component one at a time.
What is EV?
EV or the Enterprise value is the first thing investors look at during mergers and acquisitions. As such, there are many factors beyond internal financial metrics that contribute to the true valuation of a company. However, funding decisions can’t be based on vague estimations. To ensure solidity in company valuations, enterprise value is used as a common reference. Though it is a theoretical value of takeover, private equity firms have evolved to rely heavily on this metric. Enterprise value indicates the amount of money needed to acquire a business.
Enterprise Value is calculated in two ways. The simplest one is:
EV = Market cap + Market Value of debt – Cash & Cash equivalents
And the elaborate version of this formula is:
EV = Common shares + Preferred shares + Market value of debt + Minority interests – Cash & Cash equivalent
Another variation of EV calculation could be:
EV = Equity Value – Non-Operating Assets + Liability and other minority stakes
As seen in the formula, enterprise value does not depend on the capital structure of a company. Thus, it can be safely used to compare companies with varying cap structures for a takeover. As a result, being part of the EBITDA multiple valuations, the enterprise value as an entity lends this character to the multiple as well. An EBITDA multiple is thus a reliable valuation tool while comparing companies with varying cap structures.
What is EBITDA?
Earnings Before Interest Taxes Depreciation and Amortization or EBITDA is used by investors to solely estimate a company’s profitability excluding the non-operating and non-controllable assets. This metric is easily derived from the financial reports maintained by a company. Analysts do not need to use complicated calculations to derive this value. It is simple and straightforward. EBITDA formula is as follows:
EBITDA = Net profit + Interest + Tax + Depreciation + Amortization
EBITDA points at the current financial health of a company. Based on this value, analysts estimate the future profit-making potential of the company. Thus, EBITDA as a part of EBITDA multiples by industry contributes as the metric that determines the profitability of companies being considered for a potential takeover.
Pros and Cons of EBITDA Multiple Valuation
EBITDA multiples valuation is a go-to technique for most investors and financial analysts dealing with high-profit mergers and acquisitions. Using this category of valuation multiple indeed has its merits; however, it is also important to note the loopholes as well. Here is a brief about the pros and cons of EBITDA multiples:
Pros of EBITDA multiples
- It can be used to evaluate various types of businesses, private as well as public. But using this multiple for public company valuations is the easiest as all financial information for such companies are readily available.
- They are best used to evaluate companies entering advanced stages of funding such as Series-B onwards. The profitability of a company is a crucial factor at this stage. The use of enterprise value as well as EBITDA together in a ratio provides investors sufficient clarity about the future profit potential of an expanding business.
- They have proven to be very useful to evaluate as well as compare companies of different sizes and capital structures. This flexibility allows a wide range of comparisons for investors to play within an industry.
- They help to evaluate companies faster in comparison to valuation multiples based on financial metrics that use cash flow and other income-generating sources.
Cons of EBITDA multiples
- They do not account for capital expenditures. Thus if a business has high capital spends, those do not feature in the multiple and might lead to skewed valuations.
- They do not consider exact cash flows as well. This again might not represent the actual financial situation of a company leading to wrong estimations.
- EBITDA multiples valuation is not regulated by any financial body. This leaves a wide berth for variations in calculations across industries. It is mostly left to the company valuation professionals and the investors involved in the takeover negotiations.
- Due to this non-regulatory aspect, it leaves open chances of misinterpretations.
EBITDA Multiples by Industry
Here is a compilation of EBITDA multiples across industries. To study this table, a couple of aspects are worth considering. Firstly, EBITDA multiples for small business or startups will be lower, in the range of 4x. Secondly, these multiples will be at a higher range for large, publicly traded companies. And lastly, since EBITDA multiples are not regulated by any federal body, fair play is expected as a good practice in business.
|Row Labels||Annual Volatility||EV to Ebitda|
|Air Freight/Delivery Services||43.54%||39.61|
|Assisted Living Services||53.87%||7.71|
|Auto Parts – O.E.M.||41.07%||11.42|
|Biotechnology – Biological Products (No Diagnostic Substances)||111.05%||40.86|
|Biotechnology – Commercial Physical & Biological Research||110.13%||19.56|
|Biotechnology – Electromedical & Electrotherapeutic Apparatus||62.78%||28.26|
|Biotechnology – In Vitro & In Vivo Diagnostic Substances||110.61%||15.51|
|Biotechnology – Laboratory Analytical Instruments||89.65%||9.63|
|Computer peripheral equipment||83.97%||11.2|
|Computer Software: Prepackaged Software||112.17%||63.98|
|Consumer Electronics/Video Chains||155.48%||16.94|
|Department/Specialty Retail Stores||83.54%||17.19|
|Diversified Commercial Services||50.40%||16.23|
|Diversified Financial Services||72.81%||4.35|
|Electric Utilities: Central||47.28%||14.84|
|Engineering & Construction||69.18%||9.95|
|Finance: Consumer Services||56.96%||2.95|
|Integrated oil Companies||61.53%||19.14|
|Internet and Information Services||59.87%||21.57|
|Managed Health Care||47.05%||44.72|
|Natural Gas Distribution||50.47%||9.9|
|Oil & Gas Production||62.40%||17.99|
|Ordnance And Accessories||77.24%||11.84|
|Other Consumer Services||42.07%||39.97|
|Other Metals and Minerals||89.21%||5.63|
|Other Specialty Stores||127.77%||10.97|
|Pollution Control Equipment||54.28%||10.17|
|Radio And Television Broadcasting And Communications Equipment||123.14%||16.16|
|Real Estate Investment Trusts||75.58%||28.93|
|Retail: Building Materials||66.18%||9.47|
|Retail: Computer Software & Peripheral Equipment||73.85%||65.73|
|Service to the Health Industry||78.43%||9.05|
|Services & Misc. Amusement & Recreation||29.34%||22.96|
|Trucking Freight/Courier Services||68.96%||10.31|
This data was compiled from the major public companies in each industry from NASDAQ, NSYE & AMEX.
Top 10 EV/EBITDA Industries
To understand how the EV/EBITDA works in the context of industries, here is a compilation of the top 10 in order of the highest value. As per this data, the hotels and resorts industry shows the maximum business value with a ratio of 73.91. This is followed by the retail of computer software and peripheral equipment at a value of 65.73, and the production and distribution of the beverages industry at 64.72. While the biological products of the biotechnology sector are in the 10th position with a value of 40.86, it is closely preceded by the electrical products industry in the 9th position with a value of 41.86.
|Industries||EV to EBITDA|
|Retail: Computer Software & Peripheral Equipment||65.73|
|Computer Software: Prepackaged Software||63.98|
|Managed Health Care||44.72|
|Biotechnology: Biological Products||40.86|
Bottom 5 EV/EBITDA Industries
Meanwhile, here are the 5 five industries with the lowest EV/EBITDA value. The medical electronics industry has the lowest value of 2.33. This is closely followed by the consumer services in the finance industry with a value of 2.95. But the consumer electronics and appliances sector seem to have performed a little better. These low values might look profitable for investors to acquire companies from these sectors at a cheaper rate, but they must take a look at the overall financial performance as well. Usually, an EV/EBITDA value of 10 is a healthy benchmark.
|Industries||EV to EBITDA|
|Diversified Financial Services||4.35|
|Finance: Consumer Services||2.95|