An EBITDA valuation can be used to derive a possible sale price for a business. This approach is used to approximate the cash flows generated by an organization, which are then used as the basis for a valuation calculation. The name is a contraction of the term Earnings Before Interest, Taxes, Depreciation, or Amortization. The formula for EBITDA is:
Earnings + Interest + Taxes + Depreciation + Amortization = EBITDA
To then employ EBITDA to value a business, look at other organizations in the same industry that have sold recently, and compare their selling prices to their EBITDA information. This yields a multiple of selling prices to EBITDA that you could use to arrive at a general estimate of what a company is worth.
For example, the president of ABC International wants to gain a general understanding of the valuation of his business, and so compares the selling prices of similar companies to their EBITDA information over the past year. The result yields a median multiple of 5x. Since ABC currently generates EBITDA of $2,000,000, this means that a valuation of $10,000,000 could be ascribed to the business.
There are a number of reasons why the EDITDA valuation concept must be considered only a very general approximation of valuation. These reasons are:
- Other acquirers may have other reasons than cash flow for paying whatever prices they paid for companies in the list of recent acquisitions. For example, they could have paid a high price to secure a valuable patent, or a low price to acquire a bankrupt business.
- The EBITDA concept does not exactly match cash flows, since it does not account for fixed asset expenditures or a number of accruals.
Given these issues, an EBITDA valuation should be one of several valuation methods used, and may only provide a general understanding of roughly the type of valuation that the owners of a business can expect to receive.