Ever wondered how much your own company is worth? Let’s find out by learning how to value a private company using earnings multiples. There are many different multiples and you need to use the right one in each situation. In particular, earnings multiples are appropriate to value mature businesses with:

• sustainable earnings,
• low capital expenditure, and
• low working capital requirements.

Businesses are usually bought and sold using multiples, the private equity industry uses the infamous EV/EBITDA earnings multiple. The reason I say infamous is because the multiple uses EBITDA, which has been highly criticized by investment greats like Warren Buffett and Charlie Munger. But like everything in life, EBITDA is not all bad and can be used as one part of your valuation arsenal.

The basics

EBITDA means Earnings Before Interest, Taxes, Depreciation & Amortization.

EBITDA = Sales – Cost of Sales – Operating Expenses

This number can be found on the income statement. If it’s not there, you can simply start with operating profit (also known as EBIT) and add back depreciation & amortization.

When private equity investors are doing a valuation, they adjust EBITDA and call the new number “sustainable EBITDA”. Sustainable EBITDA is used as an estimate for the future cash profits that will be available to the funders (i.e. the debt & equity holders) of the business.

EBITDA criticisms

EBITDA gets a lot of flak but it’s not bad if you know what it means. EBITDA is a high-level profit number and it shows you if the company is able to sell its products and pay expenses profitably. If the number is positive, you are covering basic costs.

Now let’s deal with the specific criticisms. The first criticism EBITDA receives is around the fact that it does not include capital expenditure, financing costs (i.e. interest) or taxes. This is true and is the reason why you have to use it on suitable businesses. Despite this criticism, EBITDA can be useful to gauge if a business is getting things right at its core.

The second criticism EBITDA receives is from accountants who will tell you that there is no accounting definition of EBITDA. Remember investing is not accounting. As an investor, you can make any sensible analysis that helps you to understand the economic reality of a business. And you can use those numbers in valuation. But, it is your responsibility to check what went into those numbers and ensure that you are not being bamboozled.

Enterprise value

EV means Enterprise Value. As the name suggests, it is the value of your entire enterprise. It is calculated as follows:

EV = Debt + Equity – Cash

You can rearrange it to calculate the value of equity:

Equity = EV – Debt + Cash

Debt, equity and cash are numbers that can be found on the balance sheet. But you must remember that the balance sheet shows the book value of equity (or net asset value), not the market value of equity. If you are buying or selling a business, you need the market value of equity.

Don’t let this confuse you. There are simply two equity values. Book value of equity is on the balance sheet and it is based on historical numbers. Market value of equity is the amount that you would pay for the company today, and this number has to be calculated.

Step 1: Calculating enterprise value

Enterprise value is calculated as follows:

EV = EBITDA x Multiple

For example, if EBITDA = 5 million and the multiple = 2.

Then: EV = 5 million x 2 = 10 million

Step 2: Calculating equity value

If we assume that the company has 4 million in debt and 1 million in cash, we can use the formula to calculate the market value of equity.

Equity = EV – Debt + Cash

Equity = 10 million – 4 million + 1 million

Equity = 7 million

So, 7 million is the value for which 100% of the company could be purchased. Obviously, if you were interested in buying half the company, you would be looking at a purchase price of 3.5 million.

Valuation shenanigans

Clearly, if you want to make the market value of equity go up (or down) that can be done by changing EBITDA or by changing the multiple. This is where the shenanigans in valuing a company happen.

Normally the trouble starts with seller calculating a number called adjusted (or normalized) EBITDA. They take actual EBITDA and then start adjusting it for once-off expenses that have occurred in the past year. These expenses are added back to EBITDA to make it a higher number with the rationale that these were unusual expenses. Obviously, buyers are wise to this and will counter with adjustments elsewhere.

The other major factor in the valuation is the EV/EBITDA multiple. There is no definitive calculation to get this number. This multiple is usually decided upon, based on numerous factors, such as:

• Size of the business
• Growth rate of the business
• How well the business is managed
• Market factors
• Negotiation

Remember, even though valuation methods are driven by mathematical formulae, they are still subjective and different investors will ascribe different values to the same company. That is why there is usually some wiggle room on the multiple, it is not cast in stone.

Why use EBITDA?

With all the criticism around EBITDA, why use it in valuation? The reasons are many:

• Simplicity: It is easier to negotiate between parties when there are less variables to keep track of. An EBITDA multiple gives a quick method of seeing if the acquisition price is getting too high during negotiations.
• Structuring: Multiples make it easier to structure conditions and document them in the legal agreements. Sometimes you have to describe earn-out conditions, working capital adjustment formulas, etc. Linking these to multiples makes it easy to calculate acquisition price changes.
• Comparability: It is easier to compare multiples amongst deals. Multiples are directly comparable amongst deals whereas price is not.
• Multiple expansion: The entry multiple gives an idea as to whether there is room to improve the multiple at exit. If you buy at a lower multiple and sell at a higher multiple, you can improve the return on the deal.
• Common deal language: Multiples simplify everything, but behind the scenes other valuation methods are used. These other methods, such as discounted cash flows, capture information missing from EBITDA multiples and give you other data points to consider. These methods can be translated into EBITDA multiples so that you can still use this method for negotiations and acquisition agreements.

Conclusion

If you want to value your own business (or someone else’s) you can start by using three things: EBITDA, a Multiple and the Enterprise Value formula above.

Keep in mind that EBITDA is not a comprehensive measure of business performance, but it does offer simplicity which makes it easy to use. If you’re going to use EBITDA in valuation, you have to understand its pro and cons and then combine it with other information so that you can make good conclusions.

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