EBITDA Multiples: How to avoid mistakes !

EBITDA Multiples: How to avoid mistakes !

Author: Joris Kersten MSc/ Owner Kersten Corporate Finance

Kersten Corporate Finance: M&A advisory in The Netherlands, deals in all industries, 1m to 10m EBITDA, 5m to 100m enterprise value;

Valuation Training: 4th until 8th November 2024 @ Amsterdam South (Zuidas). Financial Modelling in Excel: DCF Valuation, LBO Modelling, M&A Modelling, EBITDA multiples, ROIC/ WACC, Adjusted net debt/ Equity Bridge/ Locked Box.

Source used: Bluemountain Investment Research, September 2018, Michael J. Mauboussin.

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Introduction

Since the 1980s the investment community looks more and more at EBITDA.

(I was born in 1980, no sure whether that has something to do with this … )

EBITDA is a broad measure of cash flow, and indicates a capacity to invest and service debt.

EBITDA is also used a lot in DCF models, this in order to use an EBITDA multiple to calculate the terminal value. (instead of using “Gordon growth”)

By the way, this is quite tricky, since a terminal value can take up to 70% of an enterprise value, as we know …

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Enterprise value

With an EBITDA multiple we calculate enterprise value (EV).

This basically is the value of the core operations, excluding for example excess cash and non consolidated subsidiaries.

EV is also equal to:

·???????? Short and long term debt, plus,

·???????? Debt equivalents, less,

·???????? Excess cash, less,

·???????? Non operating assets, plus,

·???????? Equity value.

All above in “market values” obviously.

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EBITDA

EBITDA does not reflect interest, taxes or investments required to maintain the business, or to grow the business.

It also does not take growth of net working capital into account, CAPEX, and acquisitions. These are all investments.

And because EBITDA is not a GAAP measure, “adjusted EBITDA” is very popular.

Be careful here, some people just “adjust” (read: remove) all operating costs, LOL …

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EBITDA limitations

EBITDA can be very helpful, and EV/ EBITDA multiples probably make better valuations than using operating profit.

BUT, you need to be very careful !

Since when you do not see depreciation, for example, as an expense, you are not very realistic about business.

Three pitfalls are:

1.?????? EBITDA does not take investments into account;

2.?????? EBITDA does not take business risk into account. Business risk = Operating leverage. In other words: Fixed costs can potentially be very dangerous when sales goes down (fixed costs stay, and they only "leverage" with high sales). You need to model (Eg DCF modelling, LBO modelling, M&A modelling) this business risk/ operating leverage, instead of just looking at EBITDA multiples;

3.?????? Two companies with the same EBITDA and capital structure can have different “effective tax”, this changes the EBITDA multiple, and should be modelled as well.

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From theory to practise

The famous Modigliani & Miller tell us:

The value of the firm = The steady state value + future value creation.

Over the last 60 years roughly "two/ thirds" of the value of the S&P 500 price was attributable to the steady state value of the companies.

And the other "one/ third" to the future value creation of the companies.

Future value creation is dependable on 3 elements:

1.?????? Finding projects with a positive spread between ROIC and WACC;

2.?????? How much can you invest in the positive ROIC/ WACC spread projects;

3.?????? How long can you find these positive ROIC/ WACC spread projects in a competitive world.

In case you are not familiar with ROIC (return on invested capital = NOPAT/ operating assets) > WACC = value creation. Than please check my former blogs !!

I have written a lot on ROIC/ WACC since it is one of the most important issues to understand when you work in M&A, valuations, and business in general !

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The spread between ROIC & WACC

Investing in projects only creates value when the projects have a positive ROIC over WACC spread.

If the spread is zero (ROIC = WACC) than value creation is zero, and it can even become negative.

So concerning “Growth” (earnings growth = NOPAT growth) keep in mind:

1.?????? Growth (of NOPAT) creates a lot of value, only when the spread is positive and large !

2.?????? Growth (of NOPAT) has no effect when the spread is zero;

3.?????? Growth (of NOPAT) destroys value when the spread is negative.

So with a WACC of 8%, and ROIC of 8%, then NOPAT growth of whatever percentage will keep your earnings multiple on for example 12,5 times.

But when your WACC is 8%, your ROIC 16%, then 4% NOPAT growth, or 10% NOPAT growth, can increase your earnings multiple from roughly 15 times to 22 times !

So focus on growing the ROIC/ WACC spread first, and only then NOPAT growth !

Cause with a negative spread, and growth, you earnings multiple will go down !

Summarised

When you work in M&A, you should not only look at EBITDA multiples.

You need to understand the core drivers of these multiples very well:

1. Incremental ROIC (return on invested capital);
2. WACC (weighted average cost of capital);
3. The ROIC/ WACC spread;
4. Expected NOPAT (net operating profit after tax);
5. Business risk ("Operating Leverage");
6. Capital structure;
7. Tax regime (effective tax rate);
8. Depreciation/ amortisation;
9. CAPEX & net working capital;
10. Terminal value (future growth after for example 5 years).

Using “free cash flows”, instead of EBITDA, would be a good start !

This to build DCF models, LBO models and M&A models, on top of looking at EBITDA multiples !

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I hope this blog was useful,

See you next time again,

Best regards, Joris??

Source used: Bluemountain Investment Research, September 2018, Michael J. Mauboussin.