Mergers & Acquisitions

Resources: M&A Encyclopedia

Comprehensive articles on every step of the process of buying or selling a business from the most exhaustive encyclopedia of M&A articles in the industry.

EBITDA | Definition, Formula & Example – A Complete Guide

EBITDA is the most common measure of the earnings of a company in the middle market. EBITDA allows a buyer to quickly compare two companies for valuation purposes.

Most valuation methods are based on a multiple of earnings, and the most common measure of earnings is EBITDA. Once you know the EBITDA of a business, you apply a multiple to arrive at a value of the business.

Here is the strict definition of EBITDA:

EBITDA = Earnings (Net Income) Before Interest (I) + Taxes (T) + Depreciation (D) + Amortization (A)

EBITDA measures the profitability from the core operations of the business before the impact of debt (Interest), taxes and non-cash expenses (Depreciation & Amortization). It eliminates the impact of financing (Interest) and accounting decisions (Depreciation & Amortization), which can vary.

Here is a description of each component of EBITDA:

  • (E) Earnings: This is the net income of the business after all operating expenses (e.g., insurance, rent, payroll, etc.).
  • (B) Before: Referring to “Earnings Before”…
  • (I) Interest: This includes interest from all debt financing, such as loans provided by banks. Different companies have different capital structures (i.e., varying levels of debt), resulting in different interest payments, which therefore results in varying net incomes. EBITDA allows you to easily compare two businesses while ignoring the capital structure of each business, which changes post-acquisition anyway. In other words, EBITDA includes interest payments because interest payments discontinue post-acquisition in most cases (there are rare exceptions).
  • (T) Taxes: This includes city, county, state, and federal income taxes. Income taxes vary based on a number of factors and are likely to change post-acquisition. As a result, EBITDA includes taxes in its calculation. Note: Only income taxes are added back; do not add back sales or excise tax.
  • (D) Depreciation: Depreciation is a non-cash expense. Methods of depreciation vary by company based on the method of depreciation used. Actual cash flow is based on real capital expenditures, not depreciation; therefore depreciation is added back.
  • (A) Amortization: Amortization is a non-cash expense and is the “depreciation” (technically “write-down”) of intangible assets, such as patents or trademarks.

In this article, we cover the following:

  • Should I use EBITDA to value my business?
  • Are any other measures of earnings used by buyers? If so, what are they and how can different measures of earnings affect the value of my business?
  • How do I calculate EBITDA for my business?
  • What are the benefits of EBITDA? Does EBITDA ignore any important factors that buyers may take into consideration?
  • What are the downsides of EBITDA? Is EBITDA an accurate measure of cash flow?
  • What does Warren Buffett think about EBITDA?
  • How can I increase the value of my business?
  • What other metrics do buyers use instead of EBITDA?
  • Is EBITDA the same as cash flow?
  • Should I use EBITDA or adjusted EBITDA to value my business?

If you love EBITDA as much as we do, read on. EBITDA, EBITDA, EBITDA!


Table of Contents

  • Why EBITDA?
  • Example EBITDA Calculation
  • Benefits of EBITDA
  • Downsides of EBITDA
  • How to Increase the Value of Your Business
  • FAQs about EBITDA
  • Summary

Why EBITDA?

There is one primary reason buyers use EBITDA: To quickly compare two businesses with one another.

EBITDA is a rule of thumb. It is an approximate measure of cash flow available to the buyer. The goal of calculating EBITDA is to make an apples-to-apples comparison between businesses. EBITDA facilitates comparisons across companies, whether they are in the same industry or not.

EBITDA is a rough estimate of free cash flow — an estimate of the amount of cash flow available to pay back interest or debt and fund the purchase of new equipment (i.e., “capital expenditures”). Once EBITDA is calculated, buyers will dig deeper into a multitude of other factors, such as the growth rate of the company, its gross margins, customer concentration, and hundreds of additional financial and non-financial factors.

EBITDA is primarily used at the outset as a measure of earnings when a buyer is initially evaluating a company as an acquisition target. Once a buyer digs deeper, they will use other more specific measures of earnings to assess the company and will make adjustments to account for interest payments and capital expenditures. But wait… it gets more exciting. This is so common for private equity groups that they have developed a metric called EBITDA-CAPEX, which is EBITDA less the cost of capital expenditures.

EBITDA is used both in income-based and market-based valuation methods. For example, EBITDA is used to calculate the value of a business using a multiple in several income-based valuation methods. It is also used to compare multiples among similar businesses that recently sold (i.e., comparable transactions).


Example EBITDA Formula & Calculation

Net Income (Earnings, or “E”) = $700,000

EBITDA = Net income (Earnings), plus:

Plus Interest (I): $400,000

Plus Taxes (T): $300,000

Plus Depreciation (D): $200,000

Plus Amortization (A): $100,000

EBITDA = $1,700,000

($700,000 (E) + $400,000 (I) + $300,000 (T) + $200,000 (D) + $100,000 (A))


Benefits of EBITDA

  • Commonly Used: EBITDA is the most commonly used measure of earnings by buyers, sellers, investment bankers, M&A advisors, business brokers, and every other party in the middle market.
  • Straightforward Calculation: EBITDA is simple to calculate and less prone to error, thereby facilitating comparisons.
  • Eliminates Non-Operating Variables: EBITDA eliminates variables that may not impact the buyer post-acquisition, such as interest or taxes. It also removes non-cash expenses (i.e., Depreciation & Amortization), so buyers can make their own estimates regarding the amount of these expenses and then deduct the amount from cash flow based on when the money is actually expended, not when it is deducted for tax purposes.
  • Allows Comparison: Because EBITDA is commonly used and straightforward to calculate, it allows one to easily compare a business’s earnings with other businesses. This comparison also facilitates the use of comparable transactions to value a business.

Downsides of EBITDA

Rule of Thumb: EBITDA is a simple rule of thumb. Expect buyers to dig deeper into your financials than just calculating EBITDA. EBITDA is not a magic bullet. Just because your business has a high EBITDA does not necessarily mean that your business will be an attractive acquisition candidate to a buyer.

Not an Accurate Measure of Actual Cash Flow: EBITDA is not a wholly accurate measure of cash flow for a buyer post-acquisition for the following reasons:

  • Depreciation: Adding back depreciation for companies with significant depreciation and ongoing capital expenditures results is an inflated measure of earnings. EBITDA is misleading for companies with significant fixed (depreciable) assets.
  • Amortization: The same can be said for amortization, as in the case of companies with significant amortizable intellectual property (e.g., pharmaceutical companies). However, this is less common in the middle market.
  • Working Capital: EBITDA ignores working capital needs by not accounting for working capital injections that might be required by the buyer, especially in the case of high-growth companies.
  • Taxes: EBITDA also ignores the impact of income taxes. Theoretically, a company in a non-taxable state (e.g., South Dakota) may be worth more than a company operating in a state with corporate income taxes. However, this varies based on the tax strategy employed by the company.

Warren Buffett on EBITDA: Warren Buffett has offered his opinion on EBITDA more than once, as follows: “We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE, and Microsoft — they’ll never use EBITDA in their annual report. Does management think the tooth fairy pays for capital expenditures?”

Comments: Buffett does not think that EBITDA is a true representation of the company’s performance financially. It’s hard to disagree with the world’s greatest investor. But EBITDA can be carefully used to preliminarily analyze and compare the profitability between companies as it eliminates financing effects and accounting decisions. However, EBITDA should not be used as the final measure of cash flow. Adjustments should be made by the buyer to account for specific differences based on increases in working capital needs, capital expenditures, financing, and taxes. You should expect any buyer to perform these analyses on your company and should perform the calculations in advance yourself so you can maximize the post-sale cash flow to the buyer, which will ultimately maximize the value of your business.


How to Increase the Value of Your Business

While you should not ignore other factors, one of your most important focuses should be on increasing EBITDA. Every dollar increase in EBITDA increases the value of your business by its multiple.

For example, let’s say your business is likely to sell at a 4.0 multiple. If you increase your EBITDA by $100,000 per year, you will have increased the value of your business by $400,000 ($100,000 x 4.0 multiple = $400,000).

There are only two direct ways to increase EBITDA:

  1. Increase Sales:
    1. The easiest way to increase sales is to increase your prices because 100% of your price increases will fall to the bottom line. For example, if your company currently generates $10 million per year in revenue, and you increase pricing by 5%, then your EBITDA will increase by $500,000 per year ($10 million x 5% = $500,000), less any direct sales costs (e.g., commissions). If your current EBITDA is $2,000,000, your EBITDA will increase by 25% (from $2 million to $2.5 million). In essence, a 5% rise in prices can increase your EBITDA by 25%.
    2. Other methods for increasing sales primarily include creating new products or services, or selling more of your existing products and services. However, be careful before engaging in risky product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers will generally not allow you to make adjustments for any marketing campaigns or product launches that were unsuccessful when calculating EBITDA. We recommend sticking to low-risk methods of increasing your sales if you plan on selling in the next three years, such as increasing your budget in predictable marketing campaigns with measurable returns. Avoid high-risk sales or marketing strategies, such as hiring a new sales manager or launching a new marketing campaign in which you have no experience. Such strategies can drain cash flow, which decreases EBITDA and therefore decreases the value of your business.
  2. Decrease Expenses: Decreasing your expenses is often easier than increasing revenue. Doing so also has the advantage of having an immediate impact on EBITDA, and is less risky than attempting to increase revenue. The only caveat here is to not reduce expenses that the buyer would view as unfavorable — standard insurance premiums should be maintained, for example, as should normal inventory levels.

Another alternative for increasing the value of your business is to increase its growth rate so that “projected EBITDA” is used to value your business instead of “current year’s EBITDA.” The value of your business is normally based on its most recent 12-month EBITDA (trailing twelve months, or TTM). However, if you have demonstrated strong and consistent growth, you may be able to negotiate a price based on some measure of projected EBITDA.


FAQs About EBITDA

What other metrics are similar to EBITDA?

  • LTM EBITDA = Last twelve months (LTM) EBITDA
  • TTM EBITDA = Trailing twelve months (TTM) EBITDA
  • EBITDA Margin = EBITDA as a percentage of revenue
  • EBITDA/Sales Ratio = EBITDA divided by total sales, or revenue
  • EBIT = Earnings Before Interest and Taxes, also called “Operating Profit”
  • SDE = Seller’s discretionary earnings, which is the most common measure of earnings for small businesses

Which year’s EBITDA should my valuation be based on?

A valuation is normally based on the last full year’s EBITDA or trailing twelve months (TTM). In other cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and predictable. Some value may also be placed on projected current-year EBITDA if the growth rate is consistent and predictable. Some buyers may attempt to use an average of the last three year’s EBITDA, which can pull down the valuation if the business is growing from year to year.

Is EBITDA the same as cash flow?

No, they are entirely different concepts. Your cash flow can be determined by your “cash flow statement” or “statement of cash flows.” Many small businesses, unfortunately, do not prepare a cash flow statement or know how to read one.

“Cash flow” as a term is used loosely in the industry and you should always ask for a definition whenever someone uses it. We regularly use cash flow to refer to SDE or EBITDA, or the general profitability of a business.

What is Adjusted EBITDA?

Adjusted EBITDA also includes adjustments, such as the following:

  • Salary: Adjustments are made to account for the owner’s salary in excess of, or below, market rates.
  • Perks: Owner perks are added to EBITDA, such as country club dues, personal auto expenses, or travel, meal, and entertainment expenses.
  • Professional Fees: One-time professional fees, such as for a divorce or other personal legal matters, are added back.
  • Rent: Any rent in excess of, or below, market rates is added back.

Adjusted EBITDA is more common for businesses in the lower middle-market, where there may be a sole owner and the business may be paying for significant perks for the owner and/or their family.


Summary

EBITDA is not the only metric used to value small to mid-sized businesses. Buyers will take other factors into consideration when valuing your business. These include customer concentration, growth rates, brand awareness, systems, processes, margins, working capital requirements, amount of recurring revenue, availability of financing, and an array of other factors.