I’ve had a lot of conversations lately about EBITDA multiples. Generally, the question I receive is “What do you think about this multiple? Is it fair/reasonable/realistic?”. Invariably I respond with something along the lines of:
“Sure, it seems generally reasonable. But did you consider…”
“Sure, but is that a forward multiple or a trailing multiple?”
“Sure, but how did you compute the multiple”.
The challenge with EBITDA multiples is they are general in nature, and almost always contain a myriad of assumptions. Furthermore, they can be easily manipulated to suit the party using the multiple. I think Warren Buffett says it best, “People who use EBITDA are either trying to con you or they’re conning themselves.” Charlie Munger, Buffett’s right hand man goes even further “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’.” Strong words from one of the most successful businessman on the planet. Yet EBITDA continues to be the gold standard in which a company is evaluated.
Note: I have a quick trip to Dallas this week. Next week I’m home in beautiful Southern California. And the following week I’ll be in Philadelphia, Newark, and Atlantic City. If you’re in any one of those areas, hit REPLY and tell me where. It would be great to meet you face to face.
EBITDA – The Foundation
EBITDA, or Earnings before Interest, Taxes, Depreciation and Amortization forms the foundation of most multiples. Generally speaking, when someone refers a multiple of 5x, they are referring the a multiple of EBITDA (unless you work in software and technology, then it’s more likely you’re referencing a multiple of sales. Subscribers, hit REPLY and shoot me an email if you’re curious how that can be). If you want to brush up on EBITDA, take a look at some past articles here, here and here.
The reason EBITDA is used when evaluating companies is that EBITDA normalizes earnings across companies that with different levels of debt (interest), different tax structures and impacts (tax), and different investment decisions (depreciation and amortization). EBITDA is a quick and easy way to compare companies across an industry. EBITDA also approximates cash flow to the firm (rather than equity holders), which is a key component in valuation.
EBITDA – Real or Fake Expenses?
While EBITDA is an often-used metric when evaluating an acquisition because it approximates cash flow, it isn’t exactly cash flow. Cash flow is critical in valuation, because ultimately when buying an asset, the buyer is buying future cash flows. In other words, a buyer puts up money today in the expectation they will receive more money in the future than what they gave away today.
The “ITDA” of EBITDA is often referred to as non-cash expenses. But last I checked, interest, taxes and even depreciation represent very real cash outlays. Depreciation, while precisely a non-cash expense, represents a very real cash outlay from a prior period that was not or could not be fully expensed in that period. And will likely need to be replenished at some point as well (more on that next week).
Tying it Together
EBITDA is a great way to approximate cash flow. Next week we will discuss a few of the most common expenses missing from EBITDA multiples. EBITDA Multiples are a quick and easy way to evaluate and compare multiple deals across an industry, but without a comprehensive understanding of what is and is not included in EBITDA, EBITDA and EBITDA multiples are prone to misuse.
I want to help you avoid these mistakes and make great acquisitions. If your business is in acquisition mode, let’s talk about ways to work together.
Until next week!