A key assumption necessary to develop capitalization rates and valuation multiples for capitalizing EBITDA is that of the EBITDA Depreciation Factor. Before talking about this factor in detail, it will be instructive to examine the relationship between Earnings Before Interest and Taxes (EBIT) and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

EBIT, sometimes called operating income, is the beginning point for capitalizing debt-free net income or debt-free net cash flow. It is also the beginning point for developing financial forecasts for the discounted cash flow (DCF) method.

Relationship between Depreciation and EBIT

Let’s examine the relationship between depreciation (and amortization) and EBIT to see what we can learn. I’ll use bullet points to develop the logic train.

• Depreciation is a non-cash expense that flows through the income statement in the process of deriving EBIT. Amortization is a similar non-cash expense.
• Depreciation in any period is based on the existing stock of depreciable assets on a company’s balance sheet at the beginning of the period.
• Amortization in any period is based on the existing stock of amortizable intangible assets on the balance sheet.
• There is a relationship between EBITDA and EBIT that can be measured by looking at depreciation (and amortization) as a percentage of EBIT. For simplicity, let’s focus on depreciation. If EBIT is $1.0 million and depreciation is $300 thousand, depreciation expense is 30% of EBIT ($300m / $1,000m). Similarly, if depreciation is $500 thousand with the same EBIT, depreciation is 50% of EBIT. Find out the tax depreciation of your property with help from a quantity surveyor.
• Depreciation is a proxy for the need for capital expenditures for a business. If there is a lot of depreciation, chances are there will be a need for significant capital expenditures to maintain the capital stock. If a company is growing, it would not be surprising for capital expenditures to exceed depreciation in a given period, or over time.
• The ratio of depreciation to EBIT is a measure of the capital-intensity of a business. The higher the ratio, generally, the higher the level of capital-intensity.
• We derive EBITDA by adding the D&A, or depreciation and amortization, to EBIT.
• We calculate Depreciation as a percentage of EBIT (Depreciation/EBIT).
• We then calculate the EBITDA Depreciation Factor by adding one to the result of the above quotient, or [1 + (Depreciation/EBIT)]
• We calculate the EBITDA multiple by dividing the EBITDA Depreciation Factor into the base EBIT multiple derived by building up an EBIT capitalization rate – and multiple – for a particular company.

The figure below illustrates the building up of generic EBITDA multiples. It shows the following:

• Depreciation as a percentage of EBITDA is shown ranging from, effectively, 0% to 100%.
• EBITDA Depreciation Factors are then calculated i.e., 1 + (Depreciation/EBIT), and these factors range from 100% (or 1.0x) to 200% (or 2.0).
• In the third row below, hypothetical EBITDA multiples are calculated based on an assumed EBIT multiple of 11.0x. This happens to be about the EBIT multiple for Apple (11.1x), which was calculated in a previous post. Exxon’s EBIT multiple was 11.0x, or just about the same.
• Note also, looking from left to right, the implied EBITDA multiples decrease as the EBITDA Depreciation Factors increase.

Perspective on the EBITA Depreciation Factor

Depreciation can be thought of as one proxy for expected capital expenditures. It is not a perfect proxy, of course, but assume that for a company to grow, it must spend at least as much on capital expenditures in a year as the depreciation for that year. In other words, assume that a company’s capital stock is replenished by spending the cash flow created by its non-cash depreciation charges. We know that capex tend to be lumpy, but we can clearly infer something about capital intensity by examining the EBITDA Depreciation Factors.

If one company can spend a lower portion of its EBIT on capital expenditures than another, otherwise identical company, then it warrants a higher EBITDA multiple, since there’s more of EBITDA available for non-capex uses (taxes, additional reinvestment, and dividends or distributions).

Public Market Evidence

Now, we can test the general discussion above the table with some market evidence. In the previous post, we calculated the EBITDA Depreciation Factors of Apple (1.171) and Exxon (1.51). We calculated their respective EBITDA multiples as follows:

• Apple. 11.1 EBIT Multiple divided by the 1.17 EBITDA Depreciation Factor yields an EBITDA multiple of 9.5x
• Exxon. 11.0x EBIT Multiple divided by the 1.51 EBITDA Depreciation Factor yields an EBITDA multiple of 7.3x.

The markets accord a higher EBITDA multiple to Apple than to Exxon because, at least in part, it is less capital-intensive than Exxon and generates relatively more cash flow per dollar of EBIT.

The figure above has additional illustrative examples.

• The median EBITDA Depreciation Factor for the S&P 500 Index (non-financials) is currently 1.28.
• The median EBITDA Depreciation Factor for almost 600 NAICS sub-industries in the Risk Management Associates 2014-2015 Annual Statement Studies database is also 1.28x.
• Additional perspectives are shown along the bottom of the fugure.

It is not surprising that different industries have different tendencies towards EBITDA Depreciation Factors, or different percentages of Depreciation in EBIT. We look at the major non-financial sectors of the S&P 500 in the figure below.

The figure shows median and average figures for Depreciation as % of EBIT, and also the Median Implied EBITDA Depreciation Factors for nine major sectors for the S&P 500 Index. The results are sorted from lowest capital intensity to highest. The median EBITDA Depreciation Factors for four broad sectors (consumer staples, industrials, healthcare, and consumer discretionary) lie in the tight range of 1.21 to 1.22, with the information technology close at 1.27. As noted, the overall median EBITDA Depreciation Factor is 1.28x.

The materials sector has a median EBITDA Depreciation Factor of 1.43, while the energy and utilities sector have median factors of 1.62 and 1.63, respectively. These sectors are clearly more capital-intensive than the preceding sectors. Finally, the telecommunications sector has a median EBITDA Depreciation Factor of 2.20.

Private Market Evidence

We can also look at the private markets. We noted above that the median EBTIDA Depreciation Factor was 1.28 for the portion of the Risk Management Associates sub-industries for which data was available. We can see the dispersion by sector in the table below.

We noted earlier that the overall median EBITDA Depreciation Factor for the Risk Management Association’s database was 1.28, or the same as the median factor for the S&P 500 Index.

We can now look at the results of analyzing the RMA database, which is broken into 21 major sectors.

With a broader range of industry sectors, we see a broader range of Implied EBITDA Depreciation Factors for the RMA database than in the figure for the S&P 500 Index. Factors range from a low of 1.07 for finance and insurance, to a high of 1.88 and 1.99 for mining and public administration, respectively. The increase in EBITDA Depreciation Factors seems to make sense. Finance and insurance, with a factor of 1.07, is clearly less capital intensive than mining, where the factor is 1.86.

Implications for Business Valuation

We can, in fact, examine the relationship between Depreciation, EBIT and EBITDA for any company. We can do this based on its historical financial record. We also now know that there is available market evidence to assist in making judgments about the appropriate EBITDA Depreciation factor for any private company. Such judgments would be made, of course, in light of all facts and circumstances known at the valuation date.

The method we introduced for developing capitalization rates and multiples to capitalize EBITDA in a recent post is new, at least to me. Using this method requires the development of all of the assumptions necessary to develop the Weighted Average Cost of Capital (WACC) for a business and requires only one additional assumption, that of the EBITDA Depreciation Factor.

I’ll be working to further develop this analysis in future posts. In the meantime, try the Ownership Transition Bundle, which includes my books, Unlocking Private Company Wealth and Buy-Sell Agreements for Closely Held and Family Business Owners for only $35 plus s/h.

In the meantime, be well!

Chris

Question: Did you ever wonder where EBITDA multiples come from and how they relate to other valuation multiples? I hope this recent series helps.