When discussing business valuations, you might have heard the phrases EBITDA or adjusted EBITDA. Why use fancy jargon and not just talk about profits? The answer requires a two-part explanation.

EBITDA

EBITDA stands for earnings before interest, tax, depreciation and amortisation. Why is it such a key phrase in business valuations?

Recruitment and other service businesses are generally valued on a multiple of their EBITDA, so quantifying this is crucial. The key valuation formulae are:

EBITDA x multiple = enterprise value

Enterprise value + cash – debt = equity value

The term ‘earnings’ relates to profits of the business and is the start point of the calculation. But rather than taking the final profit figure for a business, we exclude certain costs. The underlying principle is to make similar businesses comparable by eliminating non-operating costs from the picture.

Let’s consider companies A and B. Each makes EBITDA of £250k one year. Company A used factoring and paid £50k of interest in the year, whereas Company B has sufficient cash reserves that it doesn’t need to use factoring. So after interest, Company A makes profits of £200k, while Company B makes £250k. Does this make Company A the more profitable business and therefore worth more?

Using EBITDA to measure profits eliminates this variation in profit as a result of the interest charge, as we look at the figure before interest, so Companies A and B would have the same Enterprise Value. This ensures that different funding structures do not skew the underlying profitability of a business compared to its peers. The difference in Companies A and B’s cash positions would be reflected in different equity values (see formula above). An acquirer would fund either business in the same way, so Companies A and B would both generate £250k of profit for the acquirer.

Following the same theme we must consider tax. If Company A is part of a large Group and therefore pays large company corporation tax rates, whereas Company B is a stand-alone business paying small company rates, the tax rate differential should not impact on the respective values of the businesses. We therefore eliminate this variation by looking at earnings before tax.

In exactly the same way, depreciation (of fixed assets) and amortisation (of goodwill) charges should not distort relative enterprise values of two businesses with the same underlying performance.

Adjusted EBITDA

So having established why EBITDA is used, the second question is why adjusted EBITDA?

Let’s look at Companies A and B again. As we know, they each made EBITDA of £250k. However, the director of Company A took a salary of £50k whereas Company B’s director only paid himself £10k as a salary, with the rest of his income coming in the form of a dividend (which is not included in the EBITDA figure). Let’s suppose that the market rate for each director’s role is £75k.

                                                             Company A             Company B

EBITDA                                                 £250,000                 £250,000 

Adjustment:

Understated director's salary

(£75,000 less salary paid)                -£25,000                  -£65,000 

Adjusted EBITDA                               £225,000                 £185,000 

We can now see that in fact Company A is more profitable than Company B on a like for like basis.

So in summary, the use of adjusted EBITDA rather than just profit is to eliminate variances which do not relate to the underlying performance of a business or which distort the profit performance, so that a true value can be established.

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