Business Valuation - In Theory and Practice

Using Valuation Methods Based on Earnings Before Inertest, Taxes, Depreciation and Amortization (EBITDA)

EBITDA is a term that is not formally defined by general accounting standards, but is used often to value companies. EBITDA stand for "operating earnings before interest, taxes, and depreciation". It is often used in the capitalization of cash flow or market approach valuation. EBITDA allows for comparison of different business with varying debt structures, tax rates and capital requirements. Because EBITDA is calculated before interest, the multiple applied against it is the inverse of the weighted average cost of capital ("WACC") to compute enterprise value which represents the total value of the company including debt.

Computing EBITDA for valuation purposes requires that you do a comprehensive analysis of historical operations as well as future projections. Ultimately, you are trying to determine the EBITDA the business will generate in the future. Historical performance serves only as a benchmark for the anticipated future levels. You want to make sure that there haven’t been any major changes that would result in future EBITDA being different. Watch for technological changes in the industry, major changes in the business such as the loss of a major customer, or loss of a key manager that is significant driver of business. Any of these factors could result in historical EBITDA results being different from future EBITDA, so keep an eye on them.

When you look at historical results, you are looking to normalize EBITDA to a recurring, predicable level free of one time anomalies. All of this is theory, the key is that if you are a business owner looking to sell your business, you want to a) ensure your historical EBITDA is as high as possible over the review period and b) ensure your EBITDA is predictable from month to month and from year to year, which lends credibility to any future projection.
If you are buying or selling a business, some of the non recurring items that you would normalize or watch for to compute EBITDA are:
  1. Revenues or expenses that are not "arms length" - this basically means that the company may be transacting with related parties such as one of the major shareholder’ company at a price that is lower or higher than if these transactions happened with a regular third party. EBITDA would have to be adjusted or "normalized" to the fair market value of these transactions.
  2. Revenues or expenses that are being generated by redundant assets of the business - this is because redundant assets are added to enterprise value after the multiple of EBITDA has been applied.
  3. Owner salaries - often these salaries are either higher or lower than the normal salary that would be drawn by a third party manager. When owners also manage the business, a large bonus may be declared at the end of the year to reduce income taxes. This bonus needs to be isolated and added back to calculate recurring EBITDA.
  4. Rent of facilities at prices above or below fair market value - in some businesses, the company does not own the facilities it occupies, but rather rents them often times from a related party such as a holding company owned by one of the shareholders. The rent may therefore be higher or lower than it would be if rented from an independent landlord.
  5. Start up costs - if a new business line or division has been started within the historical results being analyzed, these costs should be added back to normalize EBITDA. This is because the costs are essentially "sunk" and will no longer be incurred going forward unless a new business line is introduced with its respective start up costs.
  6. Lawsuits, arbitrations, insurance claim recoveries, and one time disputes - any of these which may have been settled during the review period would not recur. Therefore, they would be deducted (in the case of income i.e. an insurance claim recovery) or added back in the case of lawsuit settlement.
  7. One time professional fees - look out for expenses incurred that relate to specific matters that do not recur in the future. An example is legal fees you would have incurred in settling a legal dispute. Not only would you add back to EBITDA the settlement expense, but you also need to ensure the related legal expenses are added back. Neither the settlement nor the legal expenses are recurring so they should not affect the valuation. The same applies for accounting fees on special transactions or marketing consultant fees if you did a one-time professional campaign. Keep your eyes open for these types of professional fees; they are often left as a recurring expense when selling a business resulting in a lower valuation than you would have obtained had you scrubbed these accounts.
  8. Repairs and maintenance - one of the most overlooked categories to review is repairs and maintenance. Often, private business owners will categorize capital expenses as repairs in order to minimize taxes. While this practice definitely keeps the annual cash taxes down, at time of sale this will hurt the valuation as it reduces historical EBITDA. Therefore, an adequate review to separate and add back any of these capital items back to EBITDA is a must.
  9. Inventories - if your company provides services using equipment, often times there is inventory such as parts required to repair the equipment. Often, private business owners will carry a general allowance of parts inventory throughout the year (say $25,000 for a small warehouse) and expense all parts acquired during the year again as part of the tax planning strategy. If you have more inventory than the general allowance being carried, it would be smart to count and value this inventory as close to the time of business sale as possible. This would have the effect of improving the company’s balance sheet and results.
  10. Other income and expenses - this category in a company’s financial statements can be loaded with items that may or may not be added back to EBITDA. Pay careful attention to this, and make sure that anything that is not recurring gets added back. For example, some companies record in this category one time employee bonuses or special donation expenses so be sure to segregate those and add them back when conducting your EBITDA calculations.

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Divestopedia is a resource for entrepreneurs who want to sell their business for the best price and terms. Whether you are thinking of selling, have started a sales process, or are post-deal, we aim to arm you with the knowledge required to maximize value and limit your downside risk. Full Bio