EBITDA Multiples mislead in valuing a business! Although it is a quick and easy way to view and understand the value of a business, caution must be exercised. When determining the value of a company, close consideration should be taken when using either EBIT or EBITDA (earnings before interest and tax, depreciation and amortisation) multiples and the type of business. In addition the in particular phase of growth the business and industry is important – see previous article EBIT multiples and growth,
What is included in EBITDA?
Capital intensive companies, for example a trucking company, may own many vehicles. Depending on how they are financed, the costs could appear on the P&L as “lease costs”. Alternatively they could be addressed under “interest costs” – naturally there is a significant cash flow element and cost required to use the fleet which is a key part of the business. Where the trucks are on CHP the EBITDA value may not reflect the cost and cash flow needed to own the fleet at all! Depreciation of rigs is significant and without understanding the need to maintain and replace trucks could be a significant problem for an investor. How is this equipment funded and where does the cash come from? The cost of the interest could be more than the earnings of the business and an EBITDA or “profit” of $3m could be less than the interest cost of say $5m!
Working Capital and EBITDA
The funding of working capital is a major issue in business and again is ignored in the EBITDA multiple value. Funding stock on hand or on the water is expensive and needs to be considered. EBITDA can look ok at the end of a month or even at the end of the financial year but serious consideration must be taken for seasonality. A big demand for season related stock eg Christmas or summer or increase in work in progress in an engineering business for a big contract need to be funded. Not only do the normal working capital demands need to be funded but these increases also need to be funded. The EBITDA multiple also hides the intra-month peaks and troughs where companies stretch their payables and are active in pursuing their receivables, placing an even larger demand on cash.
All businesses required funding whether by the shareholder or third party debt which comes at a cost. EBITDA Multiples mislead as they ignore these very real costs. Speak to your advisors to ensure you have a good understanding of the funding demands of a business and what the EBITDA mean when either selling or buying.