What exactly is EBITDA?

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) refers to a company's earnings before financial expenses, taxes, depreciation, and amortization. It represents the gross operating result generated by core business operations. The objective is to exclude everything not directly tied to the company's standard operations.

To calculate it, one simply takes the company's operating profit (EBIT) and adds back any depreciation, amortization, and relevant provisions. Note that provisions for inventory and trade receivables should not be added back, as they form part of the business's normal operational activities.

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The concept of EBITDA is identical to EBITDA's French equivalent, Excédent Brut d’Exploitation (EBE), which is commonly used in France.

Why is it used so often? 

The agreed purchase price is often expressed as a multiple of EBITDA. For a buyer, it serves as a straightforward formula to calculate the number of years required to achieve a return on investment. Banks are particularly careful to lend only a reasonable multiple of EBITDA to ensure that debt service capacity is genuinely present. EBITDA is a universal ratio: all parties involved in a valuation or corporate transaction speak the same language.

What are the traps?

  • Normalization. Exceptional items included in operating income (e.g., severance pay) must be neutralized or normalized. Expenses specific to the business owner must also be adjusted to provide an accurate picture of the company's true profitability. This normalization work is delicate, as every single adjustment must be rigorously justified.

  • Weighting. To account for multiple financial years, results can be smoothed by taking an average. This average can be weighted depending on how representative each year is. Be cautious: here too, every adjustment must be substantiated to avoid a loss of credibility.

  • Net debt. Financial debt (bank loans, shareholder current accounts, etc.) must be deducted from the enterprise value calculation, taking into account any early repayment penalties. The underlying principle is that existing debt can be refinanced by the acquirer. EBITDA will therefore be used to service both pre-existing credit lines and the new acquisition debt. If surplus cash exists, it can be added to the value, provided this cash is not essential to the operating cycle. Therefore, net financial debt (Net Debt) must be subtracted from the value obtained using the EBITDA multiple method.

  • Asset value. The EBITDA method completely ignores the underlying value of the company's assets. This is particularly problematic when assets hold significant and objective value, such as real estate. It is therefore necessary to cross-reference the EBITDA method with other valuation approaches, such as Adjusted Net Asset Value (ANAV).

  • Capital expenditures. If the company must invest to maintain its machinery or production capacity, the annual investment budget—also known as CAPEX (Capital Expenditure)—should be deducted from EBITDA.

  • Working capital requirements. It is crucial to have a clear view of the company's cash flow needs, which are determined by comparing inventory, trade receivables, and trade payables. If the business grows, any increase in working capital requirements (WCR) will need to be funded.

  • The multiplier coefficient. There is no absolute rule for fixing this figure, which can make negotiations delicate. While multiples of 8 to 10 times EBITDA may be paid for publicly traded companies or high-growth businesses, a multiple of 4 to 6 times EBITDA is generally applied to most SMEs.

The EBITDA multiple valuation method is thus a framework that can bring everyone to an agreement, just as easily as it can lead to endless debates. It must be used judiciously and cross-referenced with alternative valuation methods. The guidance of corporate finance specialists—who can argue and properly weigh the various valuation components—is frequently a key factor for success in negotiations.

Article originally published in La Libre Économique by Tanguy della Faille, Partner at Fondaris, on 31/12/2011. Updated/published version on the Fondaris website with the author's permission.