The stupidity of using Multiples

We use multiples in transactions. It just sounds so nice. The EBITDA multiplier is extremely useful to communicate,
but do we understand what we actually mean by using it? This article gives insight in the danger of using EBITDA
multiples and how it can lead to making the wrong decisions.

How EBITDA triumphed

We used to have profits. Everyone was happy with it. According to bookkeepers, profit was something which was “left over”.
According to most, multiplying profits would calculate goodwill, and according to the smart ones, it would calculate the value of
equity. The net profit multiplier was the next popular thing, until suddenly we figured that net profits were outdated.

Why? More money found its way into the market. Prices of companies skyrocketed, and the net profit multiplier became an old
fashioned method which resulted in low prices which did not represent the true value of companies. We moved up the ladder to the
Discounted Cash Flow method (DCF). Too big a step. Terms such as “cash flow” and “discount rate” seemed to be too difficult to
understand right from the beginning. Moreover, DCF calculations were often poisoned with “hockey-stick” projections and fabulous
outcomes. But then, EBITDA came.

EBITDA brought us the much-needed stability. The term “EBITDA multiplier x” was something everybody in the M&A world
understood, even the interns at large investment banks jumped on the bandwagon after 2 days. One started calling the EBITDA the
operational profit. The EBITDA multiplier became the ideal combination of an unknown term and a certain random number, and it
yielded high valuations. EBITDA is per definition higher than net profits, profits before tax or EBIT. EBITDA is the “earnings before
interest, tax, depreciation and amortization” – and is now unmissable in M&A practices.

The current use of EBITDA

EBITDA is being used:

1. For formulating business prices. Nothing wrong with that. Stating an EBITDA multiplier of 4 clarifies the agreements on pricing.
Of course it will arise some discussions about the exact value of EBITDA and all other associated pricing mechanisms, such as
net working capital. However, using the term EBITDA in pricing mechanisms is not fundamentally wrong.
2. For expressing a financing opportunity: “the amount of financing is equal to EBITDA multiplied by 2.5. This brings up the same
pros and cons; it’s not bad to express it in this way. Eventually there will be a definite amount coming from a bank in the form
of a binding offer – which will put an end to all possible doubt.
3. For the valuation of a company. Nonsense. This takes away any kind of thinking about the true value of a company. It would
make everyone able to calculate the value of a company within 10 seconds.
4. To check the outcome of a DCF valuation. A thorough analysis of the company, a well-reasoned forecast and an assessment of
risks, followed by a justification of the result of the valuation by using several multiples of listed companies. A missed
opportunity.

EBITDA as a thinking model needs to go away

EBITDA now is a left-over from back in the day, when everything was possible. We actually figured out that not everything is
possible. According to the fans of the multiples, this resulted in lower multiples compared to pre-crisis multiples in 2007.

Unfortunately, the stupidity of the EBITDA methods haven’t left. The financial crisis has not taught us that a different view of
business valuation is required. At one point we agreed that net profit wasn’t the right measure of a business valuation, but in fact,
with EBITDA, we are doing exactly the same thing. The EBITDA multiplier needs to go away, for the benefit of the entrepreneur. Why?

Faked accuracy

The determination of multiples in M&A transactions for SME and mid-corporate companies suggests a certain knowledge and
accuracy. Should the multiplier be 5.0 or 5.5? Comparing to stock market multiples is a popular way of thinking. For example, if a
listed company trades at a multiplier of 8.0x, a multiplier of 6.0x for a smaller company should be acceptable, right? No, wait, let’s
make it 5.5x because the market is declining. Any further explanations of these adjustments are missing. It’s purely based on
feeling and negotiation, but it doesn’t justify any kind of calculation of the value of the company. Bartering for financial nerds.

5 times what?
A multiplier of 5 suggests for everyone, but definitely for entrepreneurs, that something with a “5” is the base for referenc e. It looks
like earning back something in 5 years, realizing a return of 20%. 5 times some kind of operational profit, which is how EBITDA is
sometimes called in spoken language. However, this is far from the case.

1. The company needs to use the EBITDA to invest. Part of the EBITDA has to be reserved for yearly investments. By using an
EBITDA multiplier, you actually do not know anything about the need for future, vital investments. Stated differently; you
assume that you do not have to invest anymore. Well, that’s not the case.
2. The company needs to pay taxes after EBITDA, around 25% of profit before tax. This lowers the free cash flow significantly.

In the example below, the consequences are clear. Company ABC has an EBITDA of €1,000. Depreciation of €250 is necessary to be
able to invest €250 every year. If we would use an EBITDA multiplier of 5, the company would be worth €5,000. Based on a free cash
flow calculation and a discount factor of 20%, the company would only be worth €2,813.

Company ABC Using the Multiplier

P/L year: 2014 Balance Sheet 2014 EBITDA 1000 1000
Revenues 5000 Machines 1000 Multiple 5 20%
COGS 1500 Company value 5000 5000
Inventory 200
Gross margin 3500 Accounts receivable 1000 Operational FCF
EBIT 750
Salaries 1750 Total assets 2200 AT -188
Other expenses 750 NOPLAT 563
Depreciation 250 Equity 1300 Depreciation 250
Investments -250
EBIT 750 Bank loans 700
Interest 50 Accounts payable 200 Operational FCF 563
Discount factor 20%
EBT 700 Total equity + liab. 2200 Company value 2813 56%
Tax 175

Net profit after tax 525

In this case, a price of €5,000 will be earned back in 9 years! The difference is explained by the need to pay taxes and to invest. In
this example, investments in net working capital have not been taken into account.

Mathematically incorrect

The multiplier does not account for the time value of money. By using the multiplier, all future EBITDA values are worth the same,
even though every entrepreneur knows that money earned today is worth more than money earned in the future. Using a discount
rate will extend the payback period significantly.

The justification of a DCF valuation

In the professional valuation practice, DCF valuations are the rule rather than the exception. Using the DCF method, future
projections and forecasts are formulated and given an economic value. In addition to future cash flows, which are calculated from
the forecasts, the discount rate is essential for the company value. Some valuation professionals compare the outcome of a DCF
valuation with a valuation based on multiples of large listed companies. This is comparing apples to oranges in an unprofessional
way. This comparison should rather be used as a double-check than as a verification for the outcome.

Conclusion

The EBITDA multiplier is useful as a tool for clear communication between M&A advisors during pricing negotiations. In business
acquisition contracts, the EBITDA multiplier is used as part of the price, in addition to excess cash and elements of net working
capital. The use of the multiplier has become inseparable from M&A practices.

When evaluating an acquisition price and when valuating businesses, the EBITDA multiplier is way too imprecise and it leads to
wrongful thinking. Using the multiplier for these purposes should always be avoided.

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