Imagine a potential buyer is going to conduct some comparable company valuation work, averaging value against earnings for a selection of similar businesses. When looking at earnings/ value multiples, the buyer has to decide which company earnings figure to focus on. Valuation analysts often focus on EBITDA (earnings before interest, tax, depreciation and amortisation) when conducting comparable company work. But why EBITDA?
Why an EBITDA multiple? It’s before a few things!
EBITDA is “before” a few things: interest, tax, depreciation and amortisation. All of these items can differ between companies, even if the operations/ activities of those businesses are similar. Interest expense is a function of how much debt a particular company has used to finance itself. Tax is going to vary between companies depending on which country the business operates in (different countries have different corporate tax rates). The tax charge for each company is going to vary depending on specific issues such as how much tax planning the business has put in place (i.e. how hard it has worked to reduce its tax charge), or whether the business has a history of prior tax losses which have been used to offset more recent taxable income and reduce recent tax bills. Depreciation and amortisation are non-cash accounting entries designed to spread the cost of a company’s investment in assets over a number of years.
EBITDA multiples help with comparability
By focussing on EBITDA multiples, what a valuation analyst is trying to do is strip out the impact of items that can differ between businesses, but have nothing to do with underlying company performance. Interest depends on how much debt one particular company has chosen to finance itself with. Tax depends on local tax rates and company-specific tax planning. Depreciation and amortisation are non cash and depend on past acquisitions and local accounting policies. The valuation analyst is trying to strip out the impact of all of these things and understand underlying company performance.
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