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EBITDA Valuation Method
There are multitudes of ways to value a company, as well as specific equity and debt claims on a company’s assets. One is the EBITDA valuation method, which relies on a multiple of EBITDA to arrive at a company’s enterprise value.
The definition of enterprise value is the total value of a firm’s equity and debt. It can be thought of as the total market value of a company’s expected cash flow stream. A company’s EBITDA is a measure of that stream. EBITDA is a company’s net income with tax, interest, depreciation, and amortization expenses added back. It is not an exact measure of a company’s cash flow, but it is one which has gained wide acceptance in the banking and investment communities.
The enterprise valuation formula is expressed as:
where EBITDA is typically projected for the next twelve months. Sometimes, the amount used is the actual EBITDA of the company over the last twelve months and is labelled as “LTM EBITDA.”
EBITDA Valuation Multiple
The multiple is usually based on comparable actual sales transactions which have occurred recently in the company’s industry, though often the derived multiples of publicly traded companies in the industry are used in addition to or in lieu of actual transactions.
Also, while a single value for the EBITDA multiple may be used, often a range is given, based on the distribution of comparable multiples, with abnormally high or low multiples excluded so as to provide a useful range for the end user of the valuation.
Valuing Equity Using the EBITDA Valuation Method
The EBITDA valuation method can be used to value a company’s total equity. After arriving at the company’s enterprise value using the formula described above, the net debt of a company is subtracted to determine the value of the equity claim on the firm’s total cash flow (methods used to directly value equity adjust the firm’s cash flow to yield the cash flow available to shareholders, which is also known as “Free Cash Flow to Equity.”
The formula to value equity using the EBITDA valuation method is:
Problems with the EBITDA Valuation Method to Value Equity
The primary problem is that this method relies on EBITDA as a measure of a firm’s cash flow, ignoring other significant factors which can impact a company’s cash flow, such as changes in working capital and capital expenditures.