May 12th, 2014
Applications of EBITDA in M&A
Deal activity in the door and window segment is picking up again. Business owners who have been involved in these sales know that acquisitions are typically valued using a multiple of the EBITDA of the target company. Just what is EBITDA, though, and why is it used to value businesses? EBITDA stands for earnings before interest, taxes, depreciation and amortization and is a proxy for a company’s cash flow. Michael Collins
To calculate EBITDA, you simply add interest expense, taxes, depreciation and amortization back to a company’s net income after taxes. The reason for calculating EBITDA is that it is a quick, standardized proxy for a company’s cash flow and is meant to ignore taxes, non-cash charges and financing decisions in the business.
Adding back taxes allows for comparing two businesses that might have different tax treatments because of their location or corporate structure on an apples-to-apples basis. Depreciation is a non-cash charge and is added back because it represents the cost of a fixed asset that is being stretched out over a period of time. You don’t write a check for your depreciation each year, so it is appropriate to add back this amount. Amortization, another non-cash charge, only comes into play when a company is spreading out the cost of intangible assets, such as patents or goodwill from a prior acquisition. Interest expense is added back to EBITDA so two companies that have made different financing decisions (e.g., taking on debt) can be more easily compared. Ignoring the items above allows a buyer to focus on the true cash generating capacity of the company. Buyers also typically allow sellers to add back to EBITDA any proven, non-recurring charges such as unusual legal expenses, costs to move the business, excess owner compensation and a variety of other charges.
Another use for EBITDA as a financial measure, in addition to applying a multiple to it to value a company, is to compare the financial performance of companies of unlike size. Dividing a company’s EBITDA by its total revenues gives the EBITDA margin of that company. A door or window manufacturer generating $5 million in EBITDA on $50 million in revenues would have an EBITDA margin of 10 percent. In the door and window industry, a 10 percent EBITDA margin represents a solid financial performance. EBITDA margins of 15 percent or more are indicative of industry leading performance and practices. In seeking acquisitions, buyers are not only looking for businesses with a strong customer base and a consistent record of growth, they seek to acquire companies that display strong EBITDA margins as another sign of their financial success.