Beware the EBITDA Multiple Trap
By Douglas Nix, Stillwater Capital Corporation
In today’s M&A environment, an EBITDA multiple is by far the most common methodology used to discuss and assess the value of a privately owned business. It is used because of its simplicity and ease of calculation.
In its basic form, the formula is:
EBITDA Multiple x Adjusted EBITDA
= Debt-free Enterprise Value
These days, almost every valuation discussion with business owners and acquirers seems to focus entirely on the EBITDA Multiple portion of the formula. This is understandable because there is widespread reporting of EBITDA multiples – its quarterly trends, averages by industry, midpoints based on transaction size, etc. But, when using reported EBITDA multiples, Mark Twain’s words, “There are three kinds of lies – lies, damn lies and statistics”, ring very true.
A recent review comparing published EBITDA multiples to the actual multiples that were used to calculate transaction values showed a marked gap between these multiples. Not surprisingly, in almost every case the published multiples are higher. The question, in the words of Boston Legal’s Alan Shore, is “Now why is that?”
The starting point is to understand how EBITDA multiples are calculated. Reporting agencies generally use the following formula to calculate Reported EBITDA Multiples:
Reported Transaction Value /
= Reported EBITDA Multiple
Seems simple enough, but the devil is in the details. There are three factors that distort the calculation of the EBITDA multiple in this formula.
- Treatment of the transaction structure in the calculation of the transaction value. For example, if earnouts or other contingent payouts are included in the transaction value before they are earned, the transaction value is inflated. If the earnout is based on achieving increased earnings, then reported EBITDA multiples should (but never do) reflect the increased earnings used to calculate the earnout, otherwise the multiple is inflated.
- Balance sheet adjustments. A common purchase price adjustment relates to working capital surplus or deficit. These adjustments are not based on earnings, yet are always included in reported transaction values.
- Inconsistent calculation of Reported EBITDA. Every privately held business requires “normalising” adjustments in order to calculate maintainable earnings. Often “Reported EBITDA” is not normalised EBITDA. In other cases, where the business owner and the acquirer disagree on the amount of the normalising adjustments, there is a negotiation to change the EBITDA multiple. Not reporting earnings after these adjustments distorts the reported EBITDA multiple.
We recently sold a business through a strong competitive bidding process.
The price was determined as follows:
- The EBITDA multiple was 7.0 times Trailing Twelve Months (TTM) normalised EBITDA, plus
- An earnout of USD 14.0m if EBITDA increases by USD 2m in one year, plus
- A working capital adjustment.
Example see TABLE A.
Using the same information, reporting agencies would have calculated the Reported EBITDA multiple as shown in TABLE B.
The same transaction, but two very different EBITDA multiples – the negotiated EBITDA multiple used to calculate the actual purchase price was 7.0 whereas the Reported EBITDA multiple was 11.9.
So, what was the actual EBITDA multiple for this transaction? Clearly, the actual multiple of 7.0 times is the answer; however, this number is never reported and herein lies the EBITDA Multiple Trap.
The EBITDA Multiple Trap
What if the business owners had used published EBITDA multiples to establish their valuation expectations? They would have been significantly over market (see TABLE C).
There is a striking and vast gap between the actual market value (USD 69m) and the Expected Market Value (USD 113m). One can easily see why many business owners have experienced great disappointment in buyers’ assessment of the value of their business and many “market value” offers have been rejected because owners and their inexperienced advisors have used Reported EBITDA multiples.
The best approach to using the EBITDA multiple method of valuation is:
- to be very cautious with any reported multiple, and
- to talk to someone who has substantial experience with actual business sales before driving your “Expected Transaction Value” stake into the ground.
Douglas NixGGI member firm
Stillwater Capital Corporation
M&A Advisory, Corporate Finance
Toronto, ON, Canada
T: +1 905 845 4340
Published: GGI Insider, No. 105, January 2020 l Photo: Jonathan - stock.adobe.com