How does EBITDA multiple works?

To gain an understanding of a company’s fundamental financial health and value, investors frequently look at metrics like net income, revenue, and cash flow. Yet, EBITDA has emerged as a critical metric in quarterly reports and financial statements. It’s used to assess how profitable various businesses and markets are. Discover how to calculate EBITDA, how to evaluate it, and the limits that it has by reading about it.

EBITDA Multiple

The EBITDA multiple is a financial ratio that compares a company’s Enterprise Value to its estimated or actual annual EBITDA. This number is used to figure out how much a company is worth and compare it to the value of other similar businesses.

The EBITDA multiple of a company is a ratio that takes into account differences in capital structure, taxation, and fixed assets. It also compares how different companies run their businesses. The ratio compares a company’s enterprise value, which is its market capitalization plus its net debt, to its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) for a given period.

How do you calculate an EBITDA multiple?

The enterprise multiple (also known as the EBITDA multiple) is a financial measure that assesses how much a company is worth in its annual earnings before interest, taxes, depreciation, and amortization (EBITDA). The formula is:

EBITDA Multiple = Enterprise Value / EBITDA

What the EBITDA metric reveals.?

Increases in EBITDA margin indicate lower operating expenses relative to sales, which should lead to greater profitability. To determine EDITBA, one uses the following formula:

EBITDA = Earnings Before Tax + Interest + Depreciation + Amortization

The following are the values to be used in this formula:

• Earning before tax: A company’s “earnings before taxes” are its profits after deducting operating expenditures like salaries and rent before paying any taxes.
• Interest: The term “interest” refers to the earnings or payments made by a business in exchange for the use of borrowed funds.
• Depreciation: Depreciation is the gradual loss of value in a company’s physical assets, such as machinery used in production.
• Amortization: Amortization is a method for assigning value to intangible assets over time.

Enterprise value: what is it?

The enterprise value of a company is the entire value of all of its assets other than liquid ones (cash, short-term investments, etc.). In the context of mergers and acquisitions, “enterprise value” is a potential purchase price. Due to its liquidity and versatility as debt repayment tools, cash and cash equivalents are generally left out of a company’s valuation. The formula for calculating enterprise value is:

To Determine the Enterprise Value:

Enterprise Value = (market capitalization + value of debt + minority interest + preferred shares) — (cash and cash equivalents)

EBITDA Multiple to Estimate a Company’s Worth

Most acquisitions of privately owned companies are valued using EBITDA and an EBITDA Multiple. Different industries have different multiples, and we need to take into account additional variables that could affect the valuation (Intellectual Property, location of the business, and others).

The EBITDA multiples of recently closed deals involving companies in a comparable industry are typically used as a benchmark. We can then apply this average to the target company’s EBITDA to determine a price (Enterprise Value).

EBITDA Multiple Uses in Financial Analysis

The metric’s versatility has led to its widespread adoption among financial experts. We can not only find out what multiple a company’s stocks are trading at but also evaluate how several businesses stack up against one another.

While building a Discounted Cash Flow (DCF) model, the EBITDA multiple plays a critical role in determining the Terminal Value. As part of our equity analysis, it can help us determine the fair market value of the target company, and it will be crucial as we discuss the parameters of acquiring a privately held business.

Companies being compared using an EBITDA Multiple should use the same time frame for their EBITDA calculations. Moreover, using EBITDA from the past versus EBITDA from the future yields different results. Most companies’ projections of their future financial performance are overly optimistic. Improvements in profit margins are a common finding in projections of the future financial state. Generally speaking, the EBITDA Multiple will increase if there is a greater expectation for future growth. Companies that have been around longer and have a broader presence will have a more significant multiple because the risk associated with such businesses is lower.

Which EV/EBITDA Ratio Is Favorable? Is It High or Low?

The lower the Enterprise Value to Earnings Before Interest and Taxes (EBITDA) ratio, the better the company may be as an investment.

• Low EV to EBITDA Ratio: Potentially Undervalued by Market
• High EV to EBITDA Ratio: Potentially Overvalued by Market

However, there are no specific and rigid criteria for determining a low or high EV/EBITDA valuation multiple; rather, the answer depends on the industry in which the target company (the business being valued) works.

For a consumer goods company, for instance, an EV/EBITDA multiple of 10.0x may be considered high. A software company valued at 10.0x may be on the low end of the valuation range typically seen in the software industry.

This means that it is impossible to make a universally applicable statement about whether or not a company is undervalued, fairly valued, or overvalued based on a single set of valuation multiples; instead, each set of multiples requires its own set of additional evaluations.

Because of this, it’s important to only compare a company’s EV to EBITDA multiple to others in the same industry and with similar features.

Limitations of EBITDA

When capital expenditures are not included, EBITDA highlights baseline profitability. This is both EBITDA’s greatest strength and possible weakness in the eyes of some. To avoid addressing problematic regions in their financial statements, firms can use EBITDA. Therefore, it may hide any threats to the company’s success.

In addition, GAAP does not acknowledge EBITDA (Generally Accepted Accounting Principles). Businesses are free to make their judgments based on how the formula is used. The wiggle room in the EBITDA formula gives businesses a way to conceal problems that auditors might discover later. That’s why it’s crucial to always collaborate with trustworthy financial specialists.

If you want additional details on how to figure out EBITDA, feel free to get in touch with us. When it comes to assisting our clients in making important choices, Eqvista is the go-to firm.