In the field of corporate finance, business valuation is not only a vital investing strategy, but it also plays a prominent role in estimating the overall current value or worth of a business through the use of objective procedures and valuing all the significant aspects related to the company. Ideally, business valuation is an essential term in accounting adequately defined as the entire process involved in identifying an objective estimate of the overall economic value of a business for various distinct reasons such taxation, sale value and instituting partnership ownership (Mercer 86). Business valuation is thus primarily performed when a firm is looking forward to selling out all or parts of its operations or amalgamates with another company (Corporate Finance Institute.Com). There are three principal approaches that are often used in valuation of a business which includes income-based method that primarily requires forecast of what a company's future income is worth, market-based approach that many or not require any estimates of what a comparable company's worth as well as the asset-based approach that entails the value of your company's assets and does not also need any forecast.
However, several variables can significantly be used for the estimates that are built into a valuation such as free cash flow, EBITDA, cash flow from operations and earnings multipliers although earnings are the most effective to consider while performing an assessment (Mercer 90). Therefore, the central focus of this paper is on the EBITDA valuation variable, which is a substantial measure of a business's potential to generate maximum operating earnings that are effectively used in estimating an appropriate sale price for a transaction through the calculation of multiple earnings before interest, taxes, depreciation, and amortization (Cornell, Bradford, and Rajiv 52). By providing a complete definition and formulas of EBITDA variable and then a detailed layout outlining the reasoning behind the preference or some of the reasons for its increased use as a valuation variable in selling a business, this paper will provide a critical overview of what EBITDA implies and how it enormously helps in uncovering the general value of a particular company. Typically, EBITDA deals with the firm's financial performance or the net income, but at some point, it can be misleading since it overlooks the cost of capital investments such as equipment and assets.
Definition of EBITDA
EBITDA is essentially an acronym for Earnings, Before, Interest, Taxes, Depreciation, and Amortization. An in-depth definition of each key term can be described as
Interest - referring to the business expenses as a result of the interest rates that arise mainly from the loans offered by a third party or a bank.
Taxes - Describes all forms of expenses that a business incurs from tax rates imposed by either their country or city.
Depreciation - refers to the gradual decrease in the company's assets value commonly known as a non-cash expense
Amortization - is also a non-cash expense that refers to the overall coat of non-balance sheet or intangible assets for a specific period.
Additionally, as one of the hugely used ways to value a business, as well as individual claims concerning equity and debt on a firm's assets, EBITDA is adequately defined as a market based valuation approach that is efficiently obtained as a financial ratio between a business value and its total earnings before amortization, taxes, depreciation expenses and interest (Cornell, Bradford, and Rajiv 55). The valuation is effectively calculated through the formula: Business Value = Multiple * EBITDA, where the EBITDA variable is estimated for the next twelve months, through the method: EBITDA = Net Profit+ Interest + Taxes+ Depreciation + Amortization
Whereas there are no legal obligations for the businesses to reveal their EBITDA according to the generally accepted accounting principles of the United States, it can effectively be calculated and reported by using the financial statements belonging to a company (Corporate Finance Institute.Com). However, to arrive at an appropriate estimate of the value, EBITDA hugely relies on multiple valuations, where the multiples refer to the ratios statistically obtained from many comparable business sales (Piekkola 28). In essence, EBITDA is a measure of the number of parties that significantly contributes to the overall business value as it puts a considerable amount of focus on the financial outcomes of the operating decisions (Corporate Finance Institute.Com). This variable, however, accomplishes this by excluding all the effects of non-operating decisions majorly comprising of existing management in the form of the significant intangible assets, interest and tax rates expenses (Piekkola 35). As a result, this provides a figure that excellently reflects the profitability operation of a business that can substantially be used to obtain an efficient comparison of companies by the investors, owners, and buyers (Piekkola 40). This is one of the primary reasons why most valuators prefer EBITDA over other valuation metrics while making decisions regarding the business that would be more successful.
Reasons for EBITDA preference or Increased Use
Notably, calculating and applying EBITDA is vital for many business owners as it plays a crucial role in obtaining a clear idea regarding the business's value as well as conclusively demonstrates to both the investors and buyers its actual worth. As mentioned above, the EBITDA variable allows the business owners to critically examine and compare profitability among different firms and industries since it significantly excludes the impacts of accounting or government and financing decisions, providing a more accurate, rawer indication of the business earnings (Wilkinson). Nonetheless, the EBITDA multiple can also be computed for companies that are continually reporting net loss principally because all the gains before depreciation, taxes, and interest are always positive (Corporate Finance Institute.Com). Also, by evaluating the cash flow before any capital expenditure, EBITDA gives a suitable estimate for optimal value particular where the capital expenses produce substandard earnings. EBITDA is also preferably used for valuation as it allows for valid comparisons between companies with varying financial leverage using both the value and cash flows to the firm.
Cornell, Bradford, and Rajiv Gokhale. "An "Enhanced multiple" corporate valuation model: Theory and empirical tests." Business Valuation Review 35.2 (2016): 52-61.
Corporate Finance Institute.Com "EBITDA Multiple: The Standard Multiple for Valuation" Corporate Finance Institute https://corporatefinanceinstitute.com/resources/knowledge/valuation/ebitda-multiple/ Accessed 26 April 2019
Mercer, Z. Christopher. "EBITDA Single-Period Income Capitalization for Business Valuation." Business Valuation Review 35.3 (2016): 86-102.
Piekkola, Hannu. "Intangible investment and market valuation." Review of Income and Wealth 62.1 (2016): 28-51.
Wilkinson, James. "EBITDA Valuation" The Strategic CFO https://strategiccfo.com/ebitda-valuation/ Accessed 26 April 2019
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Business Valuation: Estimating the Economic Value of a Company. (2022, Dec 28). Retrieved from https://speedypaper.com/essays/business-valuation-estimating-the-economic-value-of-a-company
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