What are EBITDA Multiples?
Adjusted EBITDA is a term often used in mergers and acquisitions. EBITDA is defined as “earnings before interest, taxes, depreciation, and amortization.” It is the net income of a business plus interest, taxes, depreciation, and amortization added to it. Adjusted EBITDA “adds-back” expenses a current owner may run through a business that do not reflect the typical costs to support operations. Typical add-backs include expenses that: 1) may be unusual or linked to a certain event (like a bad debt write-off or expenses related to move the business); 2) are at the discretion of the current owner (for example, payments to a spouse or child that is not active in the business); or 3) compensation to an owner or family member that may be more than the cost to replace the duties performed by that person. Typically, historical figures for adjusted EBITDA are used as a proxy to reflect the income stream a business will generate in the future.
Why is adjusted EBITDA important? Because it is commonly used to calculate, or impute, the value that is being put on a business. Value is a product of multiplying adjusted EBITDA by an EBITDA multiple. Value = An Income Stream times a Multiple. Conversely, Value divided by an Income Stream (like EBITDA) = Multiple. This is the same concept as a price to earnings multiple in the stock market. However, in the world of mergers and acquisitions, adjusted EBITDA is the income stream commonly used to determine value.
Once adjusted EBITDA has been calculated, value can be determined by applying a multiple. The multiple will reflect a few things. First, it will track the market and buyer sentiment towards that market. This is one reason why the price to earnings (P/E) multiples of tech companies tend to be so high (often over 20). Secondly, the multiple will reflect buyer motivation. For example, a buyer may pay more for a business that operates in a yet untapped geographic territory or for a business producing a complementary product. Finally, the multiple will make sense according to the performance of a business. That is to say, given the choice of two identical target businesses, one operating at a loss and the other at a profit, which would you pay more for? Owners need to have an idea of how their organization compares to others in the same market.