EDITDA vs EBIT for valuation purposes
August 28, 2021
by a searcher from Columbia University in New York, NY, USA
I'm looking at a deal for which depreciation and capex are material each year, and want to exclude them from the valuation calculation. I believe my seller expects to use an EBITDA multiple for his business, and is waving his hand at his annual capex. Have you guys seen structures or discussion patterns that have successfully climbed over this bump? For context, depreciation is nearly half of EBITDA each year.
from Harvard University in São Paulo, Brazil
I recommend doing 3 simple checks:
(1) Ask the seller: "Do you accelerate depreciation as per IFRS rules, relative to the lifetime value of the asset? Or is the annual depreciation in line with the actual depreciation of the assets?" This makes a big difference. For example, for equipment rental firms (asset intensive), IFRS allows for accelerated depreciation within the lifetime of the signed rental contract. If the rental contract is 5 years, you can depreciate the asset in 5 years, despite the equipment having an actual lifetime of 10 years. Such accounting policy allows the firm to reduce EBIT and reduce income tax. In this situation, be very careful before using 'EBIT multiple' to value the business.
(2) Calculate "Cash-to-EBITDA", which equals "EBITDA in USD, minus change in working capital in USD, minus capex maintenance in USD" (do not deduct Capex expansion nor income tax from this calculation). If "Cash-to-EBITDA" in USD is above EBIT in USD (e.g. 70% of EBITDA), this is a strong indication that EBITDA multiple is the correct multiple to use. If "Cash-to-EBITDA" is below EBIT (e.g. 40% of EBITDA), this is a strong indication that EBIT multiple is correct to use.
(3) Ask the firm how much of maintenance is booked as cost in the P&L vs. as CAPEX maintenance in the balance sheet. If the firm loads 100% of maintenance costs in the P&L (despite IFRS allowing them to load part of it in the balance sheet), the owner is usually trying to minimize EBIT and minimize income tax, which reduces the relevance of using EBIT multiple.
from The University of Chicago in Chicago, IL, USA
Also, there are many growth businesses that do not need high CapX.
2. Industry comparison is good, but should not be relied upon. Of the many businesses that I have sold, there have been many manufacturing businesses with no CapX (except for some computers and phones).
3. Why should one use EBITDA multiple, and not EBIT multiple? EBITDA eliminates impact of a) Financing, b) taxes and c) depreciation policies of the firm and the government. EBIT addresses a) and b) but is susceptible to c). Hence EBITDA is used, and not EBIT.
4. Many sellers do not understand CapX impact. It is unfortunate they are not the only ones.
5. A buyer must incorporate expected CapX in valuing a business. Using multiple of EBITDA or EBIT will either result in overpayment or loose a good deal. The ONLY way to address this doing DCF.
6. If a buyer cannot convince the seller of the CapX impact on value (and one will be hard pressed to do so explaining EBIT multiple) then one should walk. The broker often finds a buyer who does not understand this and overpays, or the seller eventually comes to senses.
7. Overpayment in such situation only reduces IRR if business succeeds (as long as debt is serviced), but it does give the buyer downside protection if business fails.
8. We have sold many businesses with CapX to PE at high multiples. A key is to understand capacity utilization.