business valuation By ALAN LEE & A.

SCOTT DAVIDSON

Misunderstood and misused

EBITDA CAN BE SEDUCTIVE, BUT BUSINESS VALUE BASED
ON IT ALONE CAN GIVE YOU INDIGESTION

Enterprise value and equity value calculation

BITDA is earnings before in-

terest (I), taxes (T), depreciation and
amortization (DA). It has many uses,
including as a basis for determining
business value and as a measure of
ability to fund debt. It is, however,
often abused and misunderstood.
Normalized EBITOA a $10,000,000

EBITDA and business enterprise Appropriate multiple b 6X

value — the basics: Capitalized discretionary cash flow aXb = c $60,000,000
Enterprise value (EV) is the value of busi- Plus: benefit of existing tax losses or shelter d $3,000,000
ness before deduction of interest-bear-
Enterprise value c+d=e $63,000,000
ing debt. It is the fundamental build-
ing block in determining shareholder or Less: interest-bearing debt f ($20,000,000)
partner values, relative values, transac- Less: capital leases 9 <S5.000,000)
tion pricing and in assessing ability to En bloc value of 100% of the
e- f - g $38,000,000
fund principal and interest debt relat-
ed payments.
A common approach to determine EV
is by taking its normalized EBITDA and applying a mul- Normalized EBITDA is a good starting point in the de-
tiple to it. The multiple can be market-based — be it de- termination of EV because, ignoring the impact of growth
rived from comparable mergers and acquisitions transac- and the requirement to make annual capital equipment
tions in the industry or from trading multiples of compa- expenditures (CAPEX), it is good proxy for the free pre-
rable public companies. The multiple can also be built up tax cash flow generated by the business' operations.
based on company-specific risk factors, comparable re- After applying an appropriate multiple the resulting EV is:
turns for comparable risk, industry and economic condi- • A simplistic but easily computed, convenient estimate of
tions. In the end, all these factors need to be considered in EV — not equity value — subject to the implicit and ex-
building an appropriate multiple. plicit limitations in both the normalized EBITDA and the
Normalized EBITDA means the average annual EBIT- multiple applied.
DA projected to be earned in the near term (one to three • A basis for studying the value of the business and a basis
years, sometimes up tofiveyears) using reasonable assump- for comparing otherwise similar businesses without the im-
tions and effectively ignoring unforeseeable fundamental pact of: unique capital (debt, leases and preference share)
changes to the business and extraordinary effects. structures; unique income tax effects; historical annual
Eor a simple example of EV and the related value of CAPEX and future CAPEX that may create capacity and
100% of the issued and outstanding shares of the corpora- income growth not reflected in the normalized EBITDA.
tion, please see table above. For purposes of debt service analysis, normalized EBIT-

CUmagazine I Junuary/February 2005 39

DA provides a measure of the ability of the
business ability to pay interest and, to a
lesser extent, principal — interest because
it is paid out before taxes and perhaps, in
short-term worst-case scenarios, before
maintenance CAFEX. However, to assess
ability to service debt before the DA is a
slippery slope in our view.
EBITDA derivatives
Industry-specific derivations of EBITDA
include EBITDAX for oil & gas or mining
industries (where X represents explo-
ration costs) and EBITDAR for industries
where a significant portion of the capital
assets are rented, leased or fmanced, such
as the airline industry (where R represents
rent/lease payments). EBITDAR some-
times means EBITDA before restructuring
charges.
For companies that have significant
CAPEX requirements, it is often appro-
priate to utilize EBITDA less CAPEX as
a more accurate proxy ofits pre-tax dis-
cretionary free cash flow. CAPEX in these
cases is that which is required to main-
tain its operations, as opposed to build-
ing capacity. Similar comments apply to
industries where a significant portion of
the capital assets are rented or leased — a
more accurate proxy of its pre-tax discre-
tionary fi-ee cash flow is EBITDAR less
CAPEX and less lease/rental payments
required to maintain its operations. In the
telecom and cable industries, EBITDA
can be greatly reduced or eliminated by
CAPEX requirements in the early years of
buiiding a system, but this is not the sta-
ble state — one needs to look beyond the
build out period to find EBITDA less
CAPEX that reflect the sustainable long
term pre-tax discretionary free cash flow.
EBITDA is illusory
Tbe EV above determined is only as good
as the inputs — the normalized EBITDA
and the matching multiple. The old adage
of "garbage in, garbage out" remains true.
Hence, understanding the inputs is the
only way to make use of the product.
In the determination of EV, the mul-
tiple applied to the normalized EBITDA
must complement the normalized EBIT-
DA — because often, what is not reflected
in the one can be accounted for in the oth-
er — albeit subjectively. To best match the
normalized EBITDA to an appropriate
multiple, it is essential to understand the
impact ofthe following questions:
• What growth has been built into the nor-
40 CZ.magazine I January/February 2005
malized EBITDA or the multiple? Users
should be careful not to double-count
growth by incorporating it into both the
normalized EBITDA and the multiple.
• Are synergies that will be realized by the
buyer of the business included in the nor-
malized EBITDA or the multiple?
• IS the normalized FBITDA in nominal
or inflation adjusted dollars?
• A buck is not a buck. What is the rel-
ative quality of the cash flow implied in
the normalized EBITDA or the multiple?
Wliere is the normalized EBITDA on the
spectrum of realization risk? Pias it been
adjusted for the probability of realization?
• Wben comparing the projected normal-
ized EBllDA to historical EBITDA, have
non-rcciirring items been consistently
dealt with?
• Is the multiple truly comparable? Has
it been engineered to be consistent with
tbe assumptions underlying the normal-
ized EBITDA calculation? The two arc in-
separably interdependent and can only be
assessed in relation to each other. They can
exacerbate or moderate the weaknesses of
EBITDA-based analysis.
So what cash flow effects are not in-
cluded in normalized EBITDA? Normal-
ized EBITDA does not reflect, by defin-
ition, the following:
• working capital needed to support the
growth implicit in the normalized EBIT-
DA or the multiple;
• maintenance CAPEX needed to sup-
port the normalized EBITDA at a steady
level and growth CAPEX to support in-
come growth implicit in the normalized
EBITDA or the multiple;
• income taxes;
• timing of realization — as normalized
EBITDA is an average, actual pattern of
"when the cash comes" may be very dif-
ferent than the implicitly even assumption
built into the EV model.
How can one best ameliorate the
above inherent limitations in the EV or
debt-service analysis based on normal-
ized EBITDA? The best answer is that it
is a very quick way to get one's initial bear-
ings ^ use the resulting EV or debt ser-
vice analysis as only a starting point or a
sanity check. Use it in combination with
other valuation techniques (discounted
cash How and net-income-based tech-
niques) to ensure more necessary perspec-
tives are brought to bear. It should not be
the only basis of analysis.
More sophisticated techniques are
beyond the scope of this article, as is an
analysis of appropriate multiples to apply
to normalized EBITDA. Rememher that
once capital structure is introduced, com-
parability dramatically diminishes. The
following summary observations put nor-
malized EBIIDA analysis in perspective:
• discounted cash flow techniques will pro-
vide tbe most comprehensive overview,
including those addressed by net-income-
based methods atid will specifically ac-
count for timing of cash flows, CAPEX,
working capital needs and time value of
money. It is best used when assessing debt
service and impact of leverage on equity-
holders;
• net-income-based methods will specif-
ically account for net income attribut-
able to equityholders. Depreciation, which
is deducted in determining net income,
is often a rough proxy for maintenance
CAPEX — though often it is an under-
estimate.
Should it stay?
EBITDA is here to stay. Like fine wine, it
is too seductive to be banished and its
formulation and ingredients will deter-
mine the quality. However, business vaiue
based on EBITDA alone will give you in-
digestion, as will a liquid dinner •—• no
matter how fine the wine.
Alan Lee, CA, is an associate and A. Scott
Davidson, CA'IFA, CBV, is a partner at Cole
& Partners in Toronto
Technical editor: Stephen Cole, FCBV, FCA,
partner, Cole & Partners