It is not recognized as a GAAP measurement of earnings. It is not the same thing as cash flow. It’s weird to pronounce. Yet, EBITDA is the most oft used measure of value in the lower middle-market, private-company world. Indeed, it’s used extensively across the entire span of public and private companies. I recall sitting in a board meeting with private equity investors and the managing partner cutting straight to the chase within just a few short minutes of beginning our presentation: “What’s your EBITDA?”
First, I have to mention pronunciation because it’s actually pretty funny, if not awkward, when someone says it differently than you in the same conversation. I’ve heard it pronounced FOUR different ways if you can believe it. I find the most common pronunciation is, “ee-bit-dah”. The other three ways I’ve heard it commonly pronounced are, “ee-bit-duh,” “ee-bit-D.A.”, and “eh-bit-duh,”. There’s clearly no one correct pronunciation, but at least the “bit” sound always seems to stay the same!
On a more serious note, let’s next discuss what it actually means. EBITDA is an acronym that stands for Earnings Before Interest Taxes Depreciation and Amortization.
A little “Accounting 101” will help us define the first component, Earnings:
Sales, less cost of goods sold, equals gross profit.
Gross profit, less selling, general and administrative expenses (SG&A), equals operating income or operating profit.
Operating income less other income/expenses (including interest) and taxes, equals earnings, net income or net profit – a true GAAP accounting measure.
Once we have earnings, we’ve got to throw a few things back into the mix which were previously subtracted out:
1. Interest – Interest expense is a function of your bank/credit financing, and financing structure is relative to each owner or ownership group. There are multiple ways to finance the same business. So, to “standardize” things we remove anything related to the financing of the business because it will not be applicable to another owner.
2. Taxes – Specifically, we’re talking about federal and state income taxes. Why? Because taxation, like interest, is specific to ownership – in this case, ownership’s legal structure, and to a lesser extent, the aggressiveness of its tax department or CPA. Therefore, we add it back to again standardize. For most businesses in the lower middle market, they will not have to worry about this add back as they are privately-held and organized as partnerships, which means income tax liability “passes thru” to the individual investor and will not be included in the company’s financials. Note, non-income state and local taxes, such as sales and use tax, and property tax, are not included in this definition for add-back purposes, as those are typically calculated the same no matter the ownership structure.
3. Depreciation & Amortization – Depreciation is the accounting method for showing the utilization of a hard, or “fixed” asset over the course of the asset’s life by periodically expensing it to the P&L. It is strictly a paper exercise. You never “pay” anyone depreciation. Similarly, amortization is how you show the use of an intangible asset (like a patent) over the course of its life. It is also strictly a paper exercise. So, because they are both non-cash expenses, we throw them both back into the mix.
Now we have the EBITDA number. From an earnings perspective, we standardized it to make it owner/financing agnostic by adding back interest and taxes. We got closer to actual cash flow by adding back the non-cash expenses, depreciation and amortization. Once the EBITDA number is determined, there is one more step required to maximize its effectiveness, and that is to adjust it.
Adjusted EBITDA is the true number in which everyone is interested. The addbacks to arrive at adjusted EBITDA include things like:
1) the incremental amount by which certain expenses in the company may be in excess of fair market value because they are reflective of current ownership (for example, owner and executive compensation, rent paid to an owner, or other services paid to an owner);
2) non-cash expenses other than depreciation and amortization, such as one-time gains or losses on the sale of assets; and
3) other, non-recurring expenses, such as one-time legal fees incurred in a law-suit, or fees incurred for implementing a new accounting system.
I’ve given examples of common add-back adjustments, but there are certainly more that could be specific to a given business.
You may be thinking that some of the add-back expenses I listed above are fairly subjective and depend on perspective, and you’d be absolutely right. Particularly, when it comes to valuation negotiation, the calculation of Adjusted EBITDA depends on which side of the table you’re sitting. Sellers will argue for more adjustments, buyers will argue for less. And, senior lenders will certainly have their own parameters for an Adjusted EBITDA number for covenant calculation purposes.
All of this brings us back to our key question: Why is EBITDA (and now we know it’s really Adjusted EBITDA) so important? I alluded to it in the previous paragraph. The answer is for the overwhelming reason that (drum roll) ... investors, potential acquirers, and lenders all look to the Adjusted EBITDA number as a proxy for both cash flow and earnings – it is neither, but it masquerades as a derivative of both (cue the accounting purists out there cringing) – and they peg their valuations of the Company to it. Let me restate that: investors, potential acquirers, and lenders all peg their valuations of the business to EBITDA.
How do they do that? This gets into the “weeds” of finance theory very quickly, but I’ll try to simplify. They first run their financial valuation model (typically using what’s called a “discounted cash flow”, or DCF, model) to arrive at a discounted present value of future cash flows. This forms the theoretical basis for valuation and it’s important to note, relies on estimated future cash flows. The business’ ability to generate cash is truly wherein lies its value.
They then frame that business value (called “enterprise value”) as a multiple of the most recent 12 months of Adjusted EBITDA (not from two years ago, nor what you plan to do next year, though those numbers can both influence the multiple). The most recent 12 months of Adjusted EBITDA is referred to as either Trailing Twelve Months (TTM), or Last Twelve Months (LTM) Adjusted EBITDA. Even though the multiple of Adjusted EBITDA isn’t the theoretical determinant of value to a would-be investor or lender, it is universally referenced and the most practical way to think about value for a lower middle-market, private business. It is a short-cut method, essentially capitalizing those twelve months of Adjusted EBITDA.
For example, historically in the lower middle market and as a generalization, a 5x to 6x multiple applied to the most recent 12 months of Adjusted EBITDA is seen as the base-case for a business enterprise valuation; whereas 7x, 8x, and 9x+ are high-side, and a 4x multiple or less would be low-side. Similarly, as mentioned above, banks and other lenders determine how much they are comfortable lending based on their calculation of the Adjusted EBITDA number. For most lower middle-market businesses, 2.5x to 3.5x the most recent twelve months Adjusted EBITDA is the maximum amount senior lenders will extend.
In addition, there are numerous variables that influence valuation and Adjusted EBITDA multiples for everyone. Prominent variables that hold sway include things like the actual amount of Adjusted EBITDA (more is of course better), Adjusted EBITDA as % of sales, industry, gross margins, and customer concentration. There are many more factors, and you can read about them in both of my related articles (article 1 and article 2 ) on what makes a business attractive to investors.
In conclusion, EBITDA, and more specifically Adjusted EBITDA, is quite possibly the single most important metric you will calculate in your business – no matter how you pronounce it! You should know that number month in and month out. It is the measure by which business value in the lower middle market is perceived and compared, and forms the basis for serious discussion with any potential investor, acquirer, or lender.