Collins
by Mike Collins
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.

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3 comments
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  1. Great explanation of the usefulness of comparing EBITA Michael. So, what is the formula most often used in evaluating the potential sale price of a company, ie, how many times annual EBITA?

  2. Jim, when I was playing the M & A game about 20 years ago the multiple was 5 times annual pre-tax earnings. Depreciation and amortization was not a big issue back then. In recent years I have heard the 5 times Ebita remains a sound rule of thumb.
    One element I would add to Mr. Collins presentation is that understanding a companys’ Ebitda is essential if you are doing an leveraged buy out and planning to finance the deal out of operations as opposed to using your own cash.

  3. Jim,
    Thanks for your comments. EBITDA multiples are more of an art than a science and a lot of factors go into determining the likely EBITDA multiple for a company. These include the EBITDA margin that I discussed, the absolute amount of the EBITDA, the growth rate of the company, likelihood of that growth rate continuing and other factors. That being said, 5-6.5X EBITDA is probably a good guess for a smaller, profitable company. In the current market, larger profitable companies trade for higher multiples, which can be as much as 9-10X EBITDA, depending on the circumstances. The other evolution we’re seeing in EBITDA multiples is that buyers are increasingly willing to pay multiples on future EBITDA, rather than just trailing EBITDA, as was usually the case in the past.
    Thanks very much,
    Mike

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