This is the seventh is a series of posts that is introducing a method for capitalizing EBITDA that, to the best of my knowledge, has not been published before. The EBITDA Capitalization Method is a method under the Income Approach to valuation, and builds up an EBITDA multiple (factor) using a variation of the Capital Asset Pricing Model.
In the last post, I put a summary of the EBITDA Capitalization Method together based on the previous posts. In this post, we will examine some analytical considerations to consider when developing an EBITDA multiple to develop an indication of enterprise value (market value of total capital, less cash, plus debt).
For convenience, the previous posts are linked below in reverse chronological order:
- Building the Discount Rate for Market Value of Equity
- Public Market Views of EBITDA: Exxon Mobil and Apple
- Building EBITDA Multiples Using the Adjusted CAPM
- A Single Period Income Capitalization Model to Capitalize EBITDA
- The EBITDA Depreciation Factor
- Capitalizing EBITDA Without Public Company or Private Transaction Comparables
EBITDA Depreciation Factor
The EBITDA Depreciation Factor measures the relationship between Depreciation and EBIT within the context of EBITDA. The factor is developed as indicated here:
The EBITDA Depreciation Factor is then used to develop an appropriate EBITDA multiple based on an EBIT multiple derived using the analyst’s preferred version of the Adjusted Capital Asset Pricing Model.
The EBIT multiple is “deflated” by the EBITDA Depreciation Factor yielding the EBITDA multiple. That algebra is simple. However, the analyst needs to get to this point with credibility.
Analysis for Developing an EBITDA Multiple based on ACAPM
Analysts must conduct a thorough analysis of a company, its industry and many other potential factors to develop valuation indications using the Discounted Cash Flow (DCF) Method.
Debt-Free Cash Flow Single Period Income Capitalization
A significant portion of value in most DCF models is accounted for by the terminal value calculation. Many analysts use a single period income capitalization model to capitalize debt free cash flow after the discrete forecast period. Estimates of terminal values often account for 60% or more of the present value of all cash flows in DCF models.
Developing an EBITDA multiple to develop valuation indications by capitalizing EBITDA in a single period income capitalization method requires the same kind of analysis used with the DCF method, and, in particular, when developing terminal value estimations.
A range of EBITDA multiples is developed below based on the indicated assumptions. The purpose of the table is to illustrate that the majority of analysis necessary to develop debt-free cash flow capitalization rates is precisely identical as that to develop EBITDA multiples.
Rows 1-13 above outline the development of EBITDA multiples from the a previous post. Lines 1-9 provide a range of familiar assumptions that result in a range of Debt-Free Net Income (Net Cash Flow) capitalization rates.
It takes just one more assumption after the development of the debt-free cash flow capitalization rate on Line 9 to develop the EBITDA multiple. We have to make an assumption about the EBITDA Depreciation Factor. That requires us to look at the expected relationship between depreciation and EBITDA (and EBIT), and also the expectation for capital expenditures.
Depreciation, Capital Expenditures and EBITDA
Clearly, there is nothing new in this portion of the development of EBITDA multiples. Appraisers utilize the method outlined above based on their specific assumptions in valuations all the time. When capitalizing Debt-Free Cash Flow in a terminal value estimation, the appraiser must also make an assumption about the then ongoing relationship between depreciation and capital expenditures.
We saw the formula for the EBITDA Depreciation Factor above. It measures the relationship between depreciation and EBIT. We know that EBIT plus depreciation equals EBITDA, so the factor is actually examining the portion of EBITDA that is consumed by (assumed replacement) capital expenditures. The greater the EBITDA Depreciation Factor, the greater the portion of EBITDA that will likely be apportioned to capital expenditures, the less is remaining for EBIT.
So, just as with the development of single period income (debt-free cash flow) capitalization for a terminal value, in developing EBITDA Depreciation Factors and EBITDA multiples, we must also examine the relationship between Depreciation (and EBIT) and capital expenditures. The analysis will be made, and the result will be factored into the assumption for the EBITDA Depreciation Factor.
In developing a single period EBITDA capitalization, it is, of course, necessary to make appropriate normalizing adjustments to EBITDA. Typical normalizing adjustments include excess owner compensation or benefits, income or expenses associated with non-operating assets, and adjustments for non-recurring items of income and expense.
It may also be appropriate to consider an adjustment of depreciation expense (and therefore, the EBITDA Depreciation Factor) (as the proxy for expected cash flows) based on or more of the following factors.
- Depreciation policy. If significant accelerated depreciation has been taken in the years leading to a valuation date, it may be appropriate to consider an adjustment to ongoing, capitalizable EBITDA to reflect that normalized depreciation should be lower than historical depreciation.
- Status of plant and equipment. If there are known deferred capital expenditures, it may be appropriate to estimate their cost and impact on the value of a business. It might be appropriate to increase ongoing depreciation based on the anticipation of higher capital expenditures. Note that this adjustment would increase the EBITDA Depreciation Factor, and therefore, would lower the concluded EBITDA multiple.
- Technology risks. If technology is in a state of rapid flux, it could be appropriate to increase the estimate of ongoing depreciation in a single period capitalization of EBITDA. It might also be appropriate to consider an additional increment to risk in the discount rate.
There could well be other considerations for analysis in particular valuation situations. The purpose of rigorous analysis is to identify these considerations and their appropriate treatment in each valuation.
Just as with a single period income capitalization of debt-free cash flow in a terminal value calculation, a capitalization of EBITDA requires an estimate of long-term growth in earnings. Since both of these methods are, by definition, on a debt-free basis, there is no benefit of leverage in any growth rate assumption.
As is clear from the previous posts, the expected growth rate is an important assumption in the development of EBTIDA multiples. This post cannot consider an examination of expected growth in detail, but factors to consider include historic growth, industry growth, the outlook for a differing growth rate in the immediate future than in the longer term, or other factors. All of these factors can be handled in a single period capitalization, but they must be handled with care and with clarity about assumptions.
I’ve said with tongue-in-cheek, the following in speeches on many occasions:
Valuation is simple. All you have to do is come up with an earnings figure and a multiple and then multiply the two. Bingo, you have a valuation!
Unfortunately, valuation is not always so simple. The degree of analysis and thoughtful consideration that is brought to the valuation table is important. There is another expression:
Garbage in, garbage out.
The purpose of this post is to remind appraisers, business owners and advisers that there is no quick answer to most valuations. Valuation is inherently an analytical process that includes considerable judgment in the form of assumptions.
This post has focused on some of the potential analytical issues that may be appropriate for consideration, in addition to all of the normal issues (i.e., in developing Lines 1-9 in the table above) in a typical valuation, when capitalizing EBITDA using the ACAPM.