EBITDA | Definition, Formula & Example – A Complete Guide

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Definition: EBITDA = Earnings (net income) Before Interest (I) + Taxes (T) + Depreciation (D) + Amortization (A)

What is EBITDA? 

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. It measures profitability from the core operations of the business before the impact of debt (interest), taxes, and non-cash expenses (depreciation and amortization). It eliminates the impact of financing (interest) and accounting decisions (depreciation and amortization), which can vary.

How is EBITDA used to value a business? 

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.

Components of EBITDA
(E) Earnings	Net income of the business after all operating expenses.
(B) Before:	“Earnings Before”…
(I) Interest:	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 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, except in rare cases.
(T) Taxes:	Includes city, county, state, and federal income taxes. Income taxes vary based on many factors and are likely to change post-acquisition. As a result, EBITDA includes taxes in its calculation.
(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, so 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.

Introduction

As the owner of a mid to large-sized business, you will encounter EBITDA as the main measure of cash flow used to arrive at your valuation.

In this article, I’ll help you decide whether EBITDA is the right measure of earnings for your business, how to calculate it, and whether it ignores any key factors buyers may need to know. 

Finally, you’ll discover other measures of earnings used by buyers, how they affect the value of your business, and how to increase that figure for a more favorable valuation. 

What is EBITDA

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

EBITDA is the most common measure of the earnings of a company in the middle market. It measures 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.

Why EBITDA Is Used

There is one primary reason buyers use EBITDA – to quickly compare two businesses with one another.

Example EBITDA Formula & Calculation

Benefits of EBITDA

Following are the major upsides to using 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, so it’s helpful for 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 and amortization), so buyers can make their own estimates regarding these expenses and then deduct the amount from cash flow based on when the money is actually expended, not when it’s deducted for tax purposes.
• Allows Comparison: Because EBITDA is commonly used and straightforward to calculate, it allows one to compare a business’s earnings with other businesses. This comparison also facilitates the use of comparable transactions to value a business.

Downsides of EBITDA

Following are the major downsides of using EBITDA:

• It’s an Approximation: EBITDA is a rule of thumb, not a magic bullet. Expect that buyers will dig deeper into your financials than this calculation. Just because your business has a high EBITDA doesn’t mean that your business will be an attractive acquisition candidate to a buyer.
• Not an Accurate Measure of Cash Flow: EBITDA isn’t an accurate measure of actual 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 in 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 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, although this varies with the company’s tax strategy.

Warren Buffett on EBITDA

Warren Buffett has offered his opinion on EBITDA more than once. Here’s what he has to say:

“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 Walmart, GE, and Microsoft – they’ll never use EBITDA in their annual report.”

What do I think about this?

Buffett clearly doesn’t think EBITDA is a true representation of a company’s financial performance. It’s hard to disagree with the world’s greatest investor, but EBITDA can be used carefully to preliminarily analyze and compare profitability between companies. Eliminating financing effects and accounting decisions is a powerful leveler.

EBITDA ignores depreciation costs, working capital needs, and income tax, so it can sometimes seem unfair to business owners looking to sell. 

That said, EBITDA shouldn’t 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, and you should perform them yourself in advance so you can maximize post-sale cash flow to the buyer. This will ultimately maximize the value of your business.

How To Increase the Value of Your Business

While you shouldn’t ignore other factors, one of your major priorities should be to increase 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).

Two Ways To Increase EBITDA

There are only two direct ways to increase EBITDA:

Increase Sales

The easiest way to increase sales is to increase your prices. 100% of your price increases (less merchant fees) will fall to the bottom line.

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, such as commissions. If your current EBITDA is $2,000,000, then 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%.

Other methods for increasing sales primarily include creating new products or services or selling more of your existing ones. But beware of risk product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers will generally not allow adjustments for unsuccessful campaigns or launches when calculating EBITDA. 

To increase your EBITDA pre-valuation, look at increasing sales, implementing higher sale prices, investing in low-risk marketing, and launching new products and services – as long as they’re a safe bet. 

I recommend sticking to low-risk methods of increasing your sales, such as increasing your budget in predictable marketing with measurable returns. Avoid high-risk strategies, such as hiring a new sales manager or implementing marketing in which you have little experience. These can drain cash flow, which decreases EBITDA and the value of your business.

Decrease Expenses 

Decreasing your expenses is often easier and less risky than increasing revenue. Doing this also has the advantage of immediately impacting EBITDA. The only caveat here is to make sure you don’t reduce expenses the buyer would see as favorable – standard insurance premiums should be maintained, for example, as should normal inventory levels.

Alternatives for Increasing the Value of Your Business

Another way to increase the value of your business is to increase its growth rate. 

The value of your business is normally based on its most recent 12-month EBITDA, also called the trailing twelve months (TTM). But, if you’ve demonstrated strong and consistent growth, you may be able to negotiate a price based on some measure of “projected EBITDA” instead of the current year’s EBITDA. 

FAQs About EBITDA

What other metrics are similar to EBITDA?

• LTM EBITDA: last twelve months EBITDA
• TTM EBITDA: trailing twelve months 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, 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. If the business is growing from year to year, some buyers may attempt to use an average of the last three year’s EBITDA, which can pull down the valuation.

Is EBITDA the same as cash flow?

No, they’re entirely different concepts. Your cash flow can be determined by your “cash flow statement” or “statement of cash flows.” Many businesses don’t prepare these.

Still, the term “cash flow” is used loosely in the industry, sometimes in reference to SDE or EBITDA, or the general profitability of a business. Always ask for a definition when you hear it. 

What is Adjusted EBITDA?

Adjusted EBITDA 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 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 in the lower-middle market, where the business may be paying significant perks to the owner and their family.

Conclusion

“References to EBITDA make us shudder,” wrote Warren Buffett in one of his Berkshire Hathaway letters. “Does management think the tooth fairy pays for capital expenditures?” 

Like it or not, EBITDA is a frequently spoken language in business valuation, especially for mid to large-sized companies. Mastering its variables helps you streamline your valuation and maximize your selling price. 

Still, the value of your business goes far beyond EBITDA. Buyers will consider customer concentration, growth rates, brand awareness, access to financing, and much more. Remember these core drivers before you finesse your valuation metric.