Many organisations promote EBITDA as a key way of valuing a business. The idea is that EBITDA (that’s Earnings Before Interest, Tax, Depreciation & Amortisation) measures the amount of cash that a business has generated during the year. While this is not quite accurate, it is a rough guide to the level of cash generated by the business from trading.
So the promoters of EBITDA as a business valuation tool state that if we found that the EBITDA of a business was say $1,000k each year and we wanted to buy this business and get a 10% return on our investment then we would be prepared to pay $10,000k. Let’s do the maths:
$1,000 return = 10% return before tax
We are using a multiple of 10 here, applied to the earnings. To get the multiple we take our required return (here 10%), turn it into a decimal (here 0.1) and use the reciprocal (1/0.1 = 10).
So using EBITDA we will get a 10% pre tax cash return on our investment if we pay $10,000k. However this approach ignores the issue of new capital investments required by the business that we have acquired. What happens, for example if the business we have bought requires a new piece of equipment for $500k in year 2? This will wipe out half of our cash return and reduce it to only 5% in that year. We will have effectively overpaid for our investment.
So the use of EBITDA is a little simplistic to give us an accurate required rate of cash return. We need to reduce the EBITDA figure by the level of average capital requirements before calculating our purchase price. EBITDA is therefore a good start point. It gives us a top end valuation; we certainly shouldn’t pay more than this figure applied to our multiplier. We should look to this figure and try and temper it down as the buyer.