Beware the Pitfalls of Using EBITDA Multiples
At the end of 2019, the median multiple of selling price to earnings before interest, taxes, depreciation, and amortization (EBITDA) across all industry sectors was 4.4 times. Business owners and their legal advisors may be tempted to rely on average or median EBITDA multiples to estimate the value of a business, but this shortcut can be costly when it’s used for federal transfer tax, litigation or M&A purposes.
Historical EBITDA is sometimes used as a rough estimate of future operating cash flow. But there are several reasons why it may differ from the metric that’s used in a discounted cash flow analysis — expected net free cash flow to equity investors and lenders. And these differences can lead to erroneous conclusions of value.
The most obvious difference between these amounts is that historical earnings may not reflect future earnings. Market conditions or changes within the company can cause a company’s earnings to grow or contract over time. This can make historical EBITDA a poor proxy for future operating cash flow. EBITDA multiples also don’t consider future working capital needs or trends that may affect future cash flow.
In addition, depreciation expense may not reflect the amount that the company needs to spend on annual capital expenditures. This is particularly true if the company’s assets are older and fully depreciated — or if the company uses accelerated depreciation methods. In the first situation, EBITDA might be artificially high, because depreciation expense would probably be lower than the annual cost of acquiring new fixed assets. The reverse might be true with the use of accelerated depreciation methods.
When an EBITDA multiple is used to value a business, the conclusion may be susceptible to earnings manipulation by the controlling shareholder. Owners planning to sell their business can take steps to increase EBITDA and, therefore, maximize their selling price. Likewise, owners valuing the business for estate planning or divorce purposes can take steps to decrease EBITDA and, therefore, minimize the value derived using an EBITDA multiple.
For example, the fictional High Growth, Inc. has been spending significant amounts of money on hiring new salespeople, marketing its products and researching new production methods. These expenses lower EBITDA over the short run, but they’ll likely increase value over the long run, which would benefit a potential buyer.
On the flip side, Cash Cow Co. has a stable level of earnings. Its owner is planning to retire soon. So she’s cut back on discretionary spending items — such as marketing, repairs and maintenance, employee benefits and staff training — to boost EBITDA over the short run and look more profitable to prospective buyers. These cutbacks may impair earnings over the long run, however.
Both hypothetical companies report $1 million of EBITDA. Which company would you rather invest in? Relying exclusively on historical EBITDA multiples, the companies would have the same value, even though Cash Cow Co. has made short-term spending cuts that would likely compromise its ability to generate operating cash flow in the future.
Leave it to the Pros
EBITDA multiples have their place in the science of valuing a business. In fact, credentialed valuation experts may use EBITDA multiples when valuing businesses under the market approach or when performing sanity checks on value estimates derived under other methods. But when laypeople rely exclusively on such simplified multiples without making adjustments for how EBITDA differs from operating cash flow or what’s expected to happen in the future, it can lead to erroneous business decisions. A credentialed business valuation professional can help you get it right.