Avoiding expensive mistakes by understanding multiples of EBITDA
A multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) is a means to reflect the economic value of an operating business and is a significant driver of sale price discussions in M&A transactions. EBITDA represents the earnings stream (free cash flow) produced by a company available for distribution to the investor.
Multiples are rooted in the conceptual notion of the desired rate of return of the investor and risk. A specific investment return is termed the cost of capital; the cost of capital is expressed as capitalization rates and discount rates. Applying the desired rate of return, the multiple, to the expected benefit stream, EBITDA, determines the value of the company.
Risk is the probability of loss or not achieving the EBITDA necessary to produce the desired rate of return. Risk changes with economic conditions, availability of credit and the size of a company; the higher the multiple, the lower the risk, and the higher the value of the business.
The buyer’s multiple, perceived risk and rate of return, applied to the company’s EBITDA, the earnings steam, drives price and terms in an M&A transaction.