If you’re considering selling your company, then you’re likely aware that EBITDA is a common valuation metric. But, what is EBITDA? And why should you care?
Let’s start with a definition: EBITDA stands for earnings before interest, taxes, depreciation and amortization. Before you fall asleep, let’s pivot to why this is useful: EBITDA is used as a proxy for the level of cash generated by a company’s operations (without noise from non-operational factors).
Unlike other cash flow metrics, EBITDA is relatively simple to calculate. It requires only five inputs and can typically be calculated quickly from the face of a company’s income statement. When considering the level of cash that a company generates from operations, it’s useful to remove non-operational impacts on cash flow. Therefore, EBITDA gives investors a metric to easily compare your company with others.
The following are four reasons why EBITDA is useful in considering the value of a company:
Even with all of these advantages, it is important to remember that there are limitations to the utility of EBITDA. For example, EBITDA ignores the amount a company must spend on capital expenditures (e.g. purchases of tangible assets that are capitalized to the balance sheet rather than expensed). Capital expenditures are a necessary consideration and will influence the value of a company. Two companies that each generate $4 million of EBITDA annually will be valued differently if one company has high capital intensity and spends $2 million per year on new equipment to sustain its business while the other requires only $200 thousand of capital expenditures per year to sustain its business. Therefore, while EBITDA is useful, it’s one data point among many that can indicate fair market value.
As you consider a sale of your company, it’s crucial to know what level of EBITDA your company has generated historically and what level of EBITDA your company is likely to continue generating in the future. This will position you to have an informed and transparent conversation with the buyer as to how each party views fair market value. Having prepared your own calculations ahead of time may, at the very least, save you significant time in determining whether you and the potential buyer are likely to reach agreement.
¹ Generally accepted accounting principles.
About Montage Partners
Founded in 2004 and located in Scottsdale, Arizona, Montage Partners is a private equity firm that invests in established companies in the western U.S. with EBITDA between $1 million and $5 million. Above all other investment criteria, Montage Partners invests in exceptional people. Montage Partners provides liquidity to those who have spent years of their life building great companies, Montage Partners protects those companies through a transition of ownership and Montage Partners supports the next generation of a company’s leadership in executing on growth initiatives. For more information, please visit www.montagepartners.com.