Capitalizing EBITDA Without Public Company or Private Transaction Comparables

In a recent series of posts, we developed a means to develop direct and credible multiples of EBITDA applicable to specific valuation situations. This is important because EBITDA is part of the universal business language and is a term that appraisers, business owners and market participants understand. It is also important because until now, one way to capitalize EBITDA has been by using (often incomplete and/or dated) guideline transactions in other private or public companies. The other way has been through the use of guideline public companies, which may suffer in comparability based on size and many other differences.

Since writing the posts, I have had a number of opportunities to discuss the methodology with other appraisers and with clients. These conversations have encouraged me to write this single post to summarize this “new” method. The recent posts, in reverse chronological order, are:

In this post, we lay out the methodology for capitalizing EBITDA using the Adjusted CAPM in one place.

Debt-Free Net Income Capitalization Rates

All appraisers and many market participants develop indications of Weighted Average Cost of Capital (WACC) using an Adjusted Capital Asset Pricing Model. They then use the WACC to develop capitalization rates applicable to Debt-Free Net Income (or Debt-Free Net Cash Flow). The components of building a capitalization rate applicable to debt-free net income include an equity discount rate, an after-tax debt rate, and an assumption about the portion of equity and debt in the capital structure of the entity being valued. The final assumption is that of a long-term expected growth rate of the subject enterprise. We are familiar with the four necessary assumption sets necessary to develop WACC and debt-free capitalization rates.

The cost of equity (discount rate). Assumptions include a Treasury rate, an equity risk premium, perhaps adjusted by a factor called beta, a size premium, and perhaps, something called a specific company risk factor. These components yield the equity discount rate, which was discussed in detail in a recent post called Building the Discount Rate for Market Value of Equity.
The after-tax cost of debt rate. The assumptions for the cost of debt include a pre-tax cost of debt that is relevant for the entity and a corporate tax rate.
Capital structure. The appraiser must make an assumption about the appropriate portions of equity and debt in the capital structure.
The long-term expected growth rate (of relevant earnings). An assumption about the long-term growth rate expectation for the enterprise is necessary.

The rest of determining a WACC is mechanical. The portion of equity in the capital structure (say 60%) is multiplied by the equity discount rate (say 15.0%). The portion of debt (40%) is then multiplied by the after-tax cost of debt (say 5.0%). The sum of these two products is the concluded WACC, which under my assumptions looks like the following:

WACC = 60% x 15% + 40% x 5.0% = 11.0%

Appraisers then use an assumed long-term growth rate (say 4.5%) and develop debt-free net income capitalization rate. The calculation is as follows:

DFNI Capitalization Rate = 1 / (WACC – Growth Rate)

= 1 / (11.0% – 4.5%)

= 6.5%

The concluded 6.5% DFNI capitalization rate could then be used to “capitalize” expected debt-free net earnings (or cash flow). This is either done by using the cap rate in the denominator, or by converting the cap factor into a multiple. In this case, the multiple would be 15.39x ( 1 / 6.5%)

The development of the WACC and the resulting DFNI capitalization rate is not controversial. Readers can verify this by looking at the following or other texts:

Valuing a Business Fifth Edition, Pratt, Shannon P. (with Alina V. Niculita) (New York, McGraw Hill Companies, Inc., 2008). See Chapter9.
Cost of Capital Applications and Examples Fourth Edition, Pratt, Shannon P. and Grabowski, Roger J. (Hoboken, NJ, John Wiley & Sons, Inc., 2010). See Chapter 18.
Financial Valuation Applications and Models, Hitchner, James R. (Hoboken, NJ, John Wiley & Sons, Inc., 2011). See Chapter 6.

With one more assumption, we can develop a capitalization factor, or multiple, applicable to EBITDA. We begin with EBIT, or Earnings Before Interest and Taxes.

Pre-Tax Debt-Free Income (EBIT) Capitalization Rate

We derived the DFNI capitalization rate above as 6.5% based on all of the assumptions that were specified. We can convert this debt-free net income cap rate into a debt-free pre-tax cap rate by dividing the after-tax cap rate by one minus the effective corporate tax rate. This is not a controversial conversion and looks like the following:

Pre-Tax Debt-Free Income Cap Rate = DEFI Cap Rate / (1 – Tax Rate)

Assume the effective corporate tax rate is 40%. The Pre-Tax Debt-Free Income Cap Rate is therefore 10.8%, or 6.5% divided by (1.0 – 40%). We can convert this cap rate into a multiple by dividing it into 1.0 (1.0 / 10.8%) and the Pre-Tax Debt-Free Income Multiple is 9.26x.

Pre-Tax Debt-Free Income is actually Debt-Free EBIT. So we have developed an EBIT multiple with which we can capitalize the Debt-Free EBIT of a business.

However, EBIT is not the measure of cash flow most often referred to by market participants. That would the broader measure of cash flow known as EBITDA.

Having gotten this far, how can we continue and develop a credible multiple applicable to EBITDA?

The EBITDA Depreciation Factor

We know that the difference between EBIT and EBITDA is the amount of Depreciation & Amortization that flows through a company’s income stream. I’ll use Depreciation to represent Depreciation and Amortization to simplify the discussion. The relationship is straightforward:

EBIT = EBITDA – Depreciation

Depreciation is one measure of the capital intensity of a business. The greater the current level of depreciation in a business, the greater the historic level of capital expenditures. Depreciation is not a predictive measure of future capital expenditure requirements. But the current level of depreciation is one indicator of the relative capital intensity of a business.

In words, the greater the percentage of EBIT that Depreciation represents (assuming that Depreciation is a predictor of expected capital expenditure requirements), the less EBIT will be available for management to utilize in the business, pay taxes, or make distributions to shareholders.

We can calculate the relationship between Depreciation and EBIT as follows:

Relationship = Depreciation / EBIT

If this relationship is relatively high, say 80%, a dollar of EBITDA is worth relatively less than if it is relatively low, say 20%.

Assume now that we have two companies whose EBIT multiples, as calculated above, are both 11.0x. We can convert their EBIT multiples to EBITDA multiples via the use of what I have called the EBITDA Depreciation Factor. The EBITDA Depreciation Factor is defined as:

EBITDA Depreciation Factor = 1 + Depreciation / EBIT

The EBITDA Depreciation Factor for the relatively capital intensive company (Depreciation/EBIT = 80%) is therefore:

EBITDA Depreciation Factor (Capital Intensive) = 1 + 0.80 = 1.80

Similarly, the EBITDA Depreciation Factor for the less capital intensive company (Depreciation/EBIT = 20%) os therefore:

EBITDA Depreciation Factor (Less Capital Intensive) = 1 + 0.20 = 1.20x

Recall that the EBIT Multiples for both companies was built up and found to be 11.0x. We can now convert the EBIT multiples for the two companies into their respective EBITDA Multiples. We do so as follows:

EBITDA Multiple (Capital Intensive) = 11.0 / 1.80 = 6.11x

EBITDA Multiple (Less Capital Intensive) = 11.0 / 1.20 = 9.17x

This result makes intuitive sense. Other things being equal, a company with greater capital expenditure requirements will be worth less as a multiple of EBITDA than one with lower capital expenditure requirements. We have assumed that the relationship between Depreciation and EBIT is one indication of capital intensity. Mathematically, we see that the EBITDA Depreciation Factor, as defined above, will convert an EBIT multiple into a correspondingly appropriate multiple of EBITDA.

Market Evidence of the EBITDA Depreciation Factor

We know that every profitable company has an amount of EBIT for every period as well as an amount of EBITDA. These amounts are the result of the operations of the company leading to the current period and reflective of its operation during the period.

We have looked at the relationship of Depreciation and EBIT for the S&P 500 (non-financial) companies. We showed the following table in a previous post and provide it here to illustrate that this factor is subject to analysis.

The median multiple for the EBITDA Depreciation Factor (far right column) for the non-financial companies in the S&P 500 Index is 1.28x. Different sectors tend to have different levels of the EBITDA Depreciation Factor. Utilities, with a median factor of 1.63, are more capital intensive than Consumer Staples, with a factor of 1.21.

There is evidence from the private markets about the EBITDA Depreciation Factor, as well. We performed an analysis of industry segments from the Risk Management Association’s database. This analysis included 594 companies with available data in 21 industry sectors. The analysis follows:

The median EBITDA Depreciation Factor for the entire analysis was 1.28, the same as the median for the S&P 500 Index companies. With a wider breakout of sectors in this private company analysis, we see a clearer picture of the relationship across industries. The EBITDA Depreciation Factor for the Finance and Insurance sector is 1.06, suggesting very low capital intensiveness. The Utilities and Mining sectors have factors of 1.76 and 1.86 (with a low number of observations).

The points of this brief analysis are simple:

Every company has an EBITDA Depreciation Factor for every period of its operation. The factors can be analyzed in the context of any company’s history and outlook.
There is information in the public securities market that can be analyzed to draw inferences as to the appropriate EBTIDA Depreciation Factor for any specific company.
There is information where data is collected on private companies to analyze the EBITDA Depreciation Factor.

Conclusion

Appraisers use build-up variants of the Adjusted CAPM to develop enterprise discount rates, or WACCs, which are then used to capitalize measures of Debt-Free Net Income in a single period method, or to estimate the terminal value of a discounted cash flow method using a single period income capitalization at the end of finite forecast periods. We make the assumptions necessary to do this and the method is not controversial.

We can, by taking one more step (calculating the implied EBIT multiples) and making just one more assumption, that of the appropriate relationship between Depreciation and EBIT (which we turn into the EBITDA Depreciation Factor), use the same methodology to develop credible multiples of EBITDA.

Thoughtful comments on this post will be appreciated.

Before You Go

If you would like to discuss any valuation-related matter with me in confidence, please do not hesitate to give me a call (901-685-2120) or email (mercerc@mercercapital.com).

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Until the next time, be well!

Chris