The Good, Bad and Ugly of EBITDA

Imagine a business owner having built a successful company over the past 30 years, ready to retire and now needs to determine the value of his company.

There are a variety of methods and metrics to evaluate the value of your business, and one of them is the EBITDA valuation model. Whether you are preparing for an exit strategy or simply looking to assess (a proxy) value of your business, you should get acquainted with EBITDA — Earnings Before Interest, Taxes, Depreciation and Amortization.

The EBITDA valuation model is a relatively simple calculation utilized to analyze the operating profitability of your business. In other words, it is a measure of your business’ financial performance. It reveals the financial performance of your business by calculating earnings from your core business operations, i.e., without considering the effects of capital structure, tax rates, depreciation and amortization policies.

Before we look at various characteristics of the EBITDA valuation model, let’s understand how it is calculated to measure a business’ financial performance.

How is EBITDA Calculated?

In order to calculate the EBITDA, you take the net income and add back interest, tax, depreciation, and amortization expenses.

EBITDA = Revenue – Expenses (excluding tax, interest, depreciation, amortization)

The Good Side of EBITDA

Because the EBITDA valuation model eliminates the impact of financing and accounting decisions, using EBIDTA provides a good “apples-to-apples” comparison. By adding back depreciation and amortization to EBITA, it frees the calculation of an accounting measurement that can fluctuate between corporations or even varying taxation rates in various regions. It, thus, can make companies more comparable.

When properly used, the EBITDA valuation model can provide a picture of efficiency and profitability of your business. EBITDA is useful for evaluating corporations in the same industry with broadly distinct capital structures, tax rates, and depreciation and amortization policies.

The Bad Side of EBITDA

A major issue with the EBITDA valuation model resides in its misappropriation. Indeed, EBITDA is occasionally misperceived as cash flow. EBITDA is not even a proxy for cash flow, since it doesn’t measure actual cash flowing into a company. It discounts many factors that affect the true cash flow of your business.

Another critic of the EBITDA valuation model is that it can be open to manipulation and abuse. Since the EBITDA valuation model disregards important items such as interest, depreciation, taxes, and amortization, it may provide a misleading picture of the business and its profitability.

The Ugly Side of EBITDA

The EBITDA valuation method can get “ugly” when it is used as a key measure in making investment decisions. An EBITDA valuation, a non-GAAP method can mislead investors. Indeed, EBITDA is a non-GAAP metric and some unscrupulous companies may use the margin for instance to mislead or misrepresent the true profitability of the business. That is because EBITDA excludes any calculations regarding debt / interest payments corroding profitability.

In the end, EBITDA is a fair metric to analyze the profitability between companies but not for the cash flow. If you are using EBITDA, always use it along with a Free Cash Flow Statement. As a matter of fact, our firm requires a multi-dimensional business valuation approach from accredited valuation firms, incorporating such factors as two asset-based approaches, Single Period Capitalization, Excess Earnings Method, and three real world closing comparatives for revenue, cash flow, and EBITDA.

By taking into account multiple valuation factors and properly weighing them, instead of a single EBITDA metric, a seller – and buyer – will arrive at a much more accurate valuation picture, essentially creating the basis for a deal both parties can agree upon.