The terms EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation) and EBITA were introduced in the USA 30 plus years ago as a practical measure of the financial performance of a business, which can then be compared with other similar businesses, whilst excluding the effects of corporate taxation, capital spending and financing working capital, which can be different from one business to another. So charges including depreciation, interest paid and received, taxation and amortisation (e.g. of goodwill) are excluded.
Over the years these terms were refined to allow for “add backs” (which can be either one way or the other), often known as “normalising adjustments”, such as directors excess remuneration and other remunerated benefits of directors/family members and other expenses either above or below market rates, including other adjustments such as allowances for substantial capital spending, hence “Adjusted EBITDA”.
This performance measuring tool was subsequently extended to cover business valuations, which has now become common place amongst both SME and large UK companies, which can also include unincorporated businesses, such as partnerships and sole traders etc.
The EBITDA multiple can be used to directly compare those businesses that may have differing levels of investment in the business (capital expenditure) as well as differing levels of debt. In effect, the EBITDA method is an attempt to value the business based on an operating profit, before any entries relating to the capital structure of the business are put through, such as interest on loan repayments. But the EBITDA multiple needs careful use, particularly where businesses are displaying low profit margins, otherwise an estimated valuation using EBITDA figures may not be accurate.
It is important to realise that the EBITDA valuation method is used to derive a value from the company’s financial performance in terms of profitability before various uncontrollable or non-operational expenses and is not therefore, to be added to the Net Asset Value – a mistake often made by business people unfamiliar with valuation methods. (NB. Businesses with low profits but high net assets would typically be valued on the Net Asset Valuation method, which may (but not always) include an element for goodwill, usually calculated as a multiple of sustainable profits before tax).
Although widely used in many areas of finance when assessing a company’s performance (e.g. securities analysis) EBITDA and EBITA are financial measurements that are not recognised by the GAAP (Generally Accepted Accounting Standards) in the UK nor the US Securities & Exchange Commission and its application has always been controversial amongst members of the UK accounting profession.
It is important to remember that capital expenditure is required to maintain the asset base, which in turn allows for profit generation. Depreciation charges are a good approximation of the capital expenditure required to maintain an asset base.
When EBITDA is employed in valuing a business, it needs to be “adjusted” which should include any “add-backs” as part of the “normalising adjustments” which will typically take into account of items such as:
- Below fair market rates for sales, purchases or expenses
- Owners salary or bonuses that are not at a fair market rate
- Repairs and maintenance charges that should have been capitalised (eg improvements)
- Non-recurring expenditure, including but not limited to professional and legal fees, patent & trademark fees, donations, employee bonuses etc
- Stock levels that are too high for one reason or another
Adjusted EBITDA Multiples
A multiple is applied to the “Adjusted EBITDA” figure but this is not arrived at in the same way that Price to Earning ratios are arrived at in the UK, which is directly related to the performance of quoted companies on the Listed Securities Market (as commonly measured by the FTSE Actuaries Share Indices Price to Earnings Ratios and where a discount up to and over 50% is applied for private Companies). The EBITDA multiple in the valuation process is often based on an industry based average, calculated on a sample of transactional values and multiples of similar sized businesses sold. The multiplier figure for SME company valuations, is usually between 3 and 5, sometimes higher eg 7 or 8 or higher still, when a “special purchaser” is involved ie a purchase for strategic reasons; the actual multiplier taking into account risk factors, business environment, market potential etc.
N.B.For information on EBITDA Multipliers and their relation to Risk Factors please CLICK HERE.
When evaluating the value of a business, it is important to understand what “adjustments” have been made (or not been made) and what multiplier has been used. These must be seen to be fair and reasonable, otherwise a false impression of value could easily be made.
It is possible that in some cases, the EBITDA valuation technique can be manipulated and therefore, misused and this could apply in the normalising adjustments. Particular care must be taken to check through any adjustments, to ensure that they are seen to be fair and reasonable.
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