What is adjusted EBITDA?

15 May 2024

By: Steven Kay bizval business valuation expert.

Firstly, let’s break down EBITDA – Earnings Before Interest Tax Depreciation and Amortisation. That sounds like you need to be a qualified accountant to understand it, but it’s not as tricky as it sounds.

EBITDA is a useful proxy for cash operating profit, although these numbers aren’t quite the same. If you work through the acronym slowly, the first thing you’ll notice is that interest isn’t deducted (or added) in this number. This means that the structure of the balance sheet has no impact on EBITDA. Also, there’s no tax expense in this number, so different tax rates have no effect.

As for depreciation and amortisation, these are non-cash items related to assets that decrease in value over time. Different companies apply different write-off periods, so EBITDA is a way of taking that distortion out of the system.

At heart, EBITDA is a way to make company results more comparable, which is why this metric is so widely used by investment professionals. This makes it important for valuations. Of course, this is where creativity comes in, as various approaches can be made to calculate an adjusted EBITDA for a valuation.

How does EBITDA differ to free cash flow?

We use EBITDA as a means of comparing businesses with different capital structures. One company may be heavily debt-funded with a large amount of fixed assets, while another can have limited debt and assets, but how does this affect their value if their EBITDA is the same?

This is where the adjusted part of “what is adjusted EBITDA” comes in. We’ll assume the first is a logistics business with 10 trucks and the other is an accounting firm with 10 laptops. For this example, they both generate the same amount of EBITDA, but it’s only logical to assume that the trucks will be more costly over time than the laptops.

The ability of each company to generate its income is reliant on having the assets to do so. Accordingly, we need to allow for the trucks and laptops to be replaced over their useful lifetime. This figure becomes the maintenance expense added back. Additionally, we also need to allow for growth through an expansion capital expense. Once we have calculated these maintenance and capital expenses we can determine the free cash flow in the company.

The logistics company would likely have a lower free cash flow than accounting firm, given the higher cost of the assets, but there’s a bit more to it.

What is adjusted EBITDA compared to SDE, EBITDA+,EBITDABC, etc.?

There are a number of approaches, and increasingly creative acronyms, but fundamentally we are looking to normalise earnings. Typically, aside from pure EBITDA adjustments, one should also look at the owner(s) salary and the lease rental rate – in instances where the property is owned.

The owner(s) of a business are often over- or underpaid compared to what would be expected by a third party. This may be a cashflow decision or due to tax structuring but in either case, it’s critical to understand the role they play and what it would cost (or save) when replacing them.

Where a property is owned by a related party, or even inside the entity in question, one must also adjust for a fair market rate. It may be preferential to over- or underpay a related property holding company but this will skew the valuation unless normalised. Likewise, if a property is held in the same entity, it won’t be paying a rental to itself but this will artificially inflate the earnings.

Accordingly, we substitute the existing rental and owner’s salary expenses with a fair market rate. Once adjustments are made, the result is often referred to as SDE (Seller’s Discretionary Earnings) – i.e. what a third party could expect the company to generate. This provides a fair view of what the company can generate for an investor.

Can I also adjust for blank?

What could blank be you ask? Well, our logistics company probably doesn’t need a Lamborghini for high-speed deliveries and the accounting firm would be fine with Dell laptops instead of MacBooks, yet far too many private companies have income and expenses that aren’t reflective of how an objective third party might run the business.

Can you adjust for them? Yes, but there should be a good reason. A buyer is looking for clarity and any adjustments should be easy to explain. The Lambo example is fairly easy to explain to a buyer, but if your staff are used to MacBooks they’re not going to want to change. A buyer will understand adjusting elements that aren’t part of the operation but anything related to how it generates income will be a cause for concern.

This speaks again to “what is adjusted EBITDA?” Ideally, we would want any adjustments made to be reasonable to both the buyer and seller. Rather than making adjustments on paper, it’s generally best to take the time to affect those changes in the books. In some cases, once the company is self-sufficient, you may not want to sell at all.

What about the future potential?

We’ve dealt with “what is adjusted EBITDA” sufficiently by now. What will often be proffered next is the benefit that a buyer will achieve through synergies or cost optimisation. When we look at a valuation it’s not just the current earnings but how that grows or declines over time. A valuation is grounded in the future earnings that are likely to exist, not necessarily what additional value can be unlocked by the buyer.

This highlights the difference between financial and strategic buyers. A strategic buyer will generally make a better offer, but it’s exceedingly difficult to quantify by how much. A financial investor on the other hand will base their offer on what they deem to be a fair return for the earnings. This can be calculated with a reasonable degree of accuracy based on the specifics of the business and prevailing market trends.

Once we have arrived at a valuation that would be acceptable for a financial investor it provides a baseline when considering offers.

This sounds confusing, isn’t there a standard formula?

In a word, no.

What we can do however is stay in the realm of what is reasonable. Any adjustments made should be rational and include fair deductions along with additions, where suitable. If anything requires convincing, you’ve probably gone too far. A buyer will be more inclined to make a better offer when they see reasonable considerations rather than aggressive adjustments.

In summary, what is adjusted EBITDA? Well, it depends on what you adjust.

By: Steven Kay bizval business valuation specialist.