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Introduction to EBITDA
Earnings before interest, tax, depreciation, and amortization (EBITDA) are a measure of company profits that can be calculated from the publicly available information in the company’s financial statements. It is therefore easy for investors to obtain and use, and it can be a tool to compare the performance of companies of similar size operating in the same industry. A multiple of the EBITDA may also be used to value a company, especially in relation to its competitors, where the multiple to be used can be obtained from dividing the market value of similar enterprises by their EBITDA and using the mean or median result as the multiple for valuing an enterprise.
EBITDA takes out of the equation those items that might obscure how the company is really performing. The tax charge can be affected by the tax strategy of the company, the availability of tax losses brought forward from previous years, or the amount of tax allowances available for capital investment. Depreciation and amortization are dependent on the extent of capital expenditure by the company and may also depend on subjective estimates of the useful life of the plant and equipment. The amount of the interest charge depends on the company’s choice of how to finance its operations. By taking out these items the EBITDA gives a figure that is closer to the actual cash generated by the operations of the enterprise, though it is not a measure of cash flow and should not be confused with this.
The use of EBITDA as a measure of profit gained popularity with private equity companies who needed to analyze the financial statements of target enterprises that were considered to be in need of financial restructuring. The target companies were often distressed enterprises that were not making an operating profit and that if acquired would need to be downsized and streamlined. The private equity investor would be looking at a measure of the potential ability of the target company to pay interest on loans if a deal were done involving a relatively high level of debt financing.
Using the EBITDA would give some idea of the availability of cash to deal with the repayment terms of debt, ignoring the current financing structure of the target enterprise. The private equity firm would especially be interested in the ability of the target company to generate funds to pay the interest and repayments becoming due in the first one or two years after being acquired.
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Advantages of using EBITDA multiples
The use of EBITDA multiples explained as a tool in valuation works because it gives an opportunity for comparison of companies with a different financing structure by looking at the profit before interest and concentrating on the cash generated in the company. This can be a better guide than operating profit especially where the potential investor intends to introduce different financing arrangements, as will usually be the case with private equity investors.
An important use of EBITDA has been for companies looking at leveraged buyouts and considering the amount of cash that can be generated by the target company so as to cover the high levels of interest payable in the first few years after the buyout has taken place. The result given by EBITDA, although not the same as a cash flow forecast (which would also need to be done in this case), would give an indication of the value of the target company and its suitability as a target for a private equity firm.
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Disadvantages of using EBITDA multiples
An EBITDA multiple is effectively a forecast of future cash flows at the appropriate discount rate. The particular multiple used will make allowances for the discount rate and for the forecast growth rate of profits within the industry in which the target enterprise is operating. Using a multiple such as the EBITDA multiple avoids the need to estimate future cash flows and calculate an appropriate discount rate, but on the other hand it can only give an approximate valuation of the enterprise.
The use of EBITDA multiples will involve finding comparable companies in the same and similar industries, comparing EBITDA and market valuations, and establishing a mean or median multiple that can be deduced from the EBITDA and market valuation of these comparable companies. Choosing the appropriate set of comparable companies is therefore an important part of this exercise. However comparable enterprises may be difficult to find, depending on the type of industry under consideration. Many industries have undergone a process of consolidation and horizontal integration in which there are now a relatively small number of major players in a particular industry, and these enterprises may not necessarily be comparable in size and activities to the target enterprise. However, if appropriate adjustments can be made to EBITDA in these companies to allow for the differences in size and operations it may be possible to arrive at an appropriate mean or median EBITDA multiple for valuing the target company.
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When to use EBITDA multiples
To understand EBITDA multiples explained properly, imagine that as EBITDA adds back depreciation and amortization to profits, it allows a clearer picture of industries that require sizeable investment in infrastructure and charge large amounts of depreciation in their profit and loss account. EBITDA multiples can therefore be useful in comparing and valuing companies within industries such as telecoms, transport, or utilities that need to develop extensive infrastructure.
Owing to the items added back to profits the EBITDA gives a larger profit figure than the operating profit of the company, so the EBITDA multiple used to value an enterprise would be a much lower figure than the price-earnings ratio. The use of an EBITDA valuation might be useful in the case of a young start-up company or a company that has recently been restructured, as it would give a clear view of the funds that the company can generate independently of how it is funded.
The use of EBITDA multiples to value a company works well when the company has been incurring operating losses. Very often, adding back tax, interest, depreciation, and amortization can turn this loss into a profit and give a potential investor an idea of the cash the business is generating. A business making operating losses can therefore be compared using EBITDA multiples to a profit-making business, and a clearer idea can be gained of the potential benefits of the target company when alternative financing structures are used.