People often speak of M&A transaction valuations in multiples of EBITDA because EBITDA is a proxy for cash flow, and cash flow is the fundamental driving force of business valuation—expected future cash flow, that is.
People knowledgeable about a particular industry likely have a decent idea of the typical EBTIDA multiples for M&A transactions in that space. However, EBITDA multiples are a short cut in our vernacular when we speak about corporate valuation. It’s a derivative of proper valuation methodologies, not a valuation methodology itself. Proper valuation methodologies are based on projected future cash flows and EBITDA isn’t necessarily equal to cash flow.
Projected free cash flow (FCF) drives valuation. EBITDA is a component of cash flow, but it is often not equal to FCF. Free cash flow is defined as:
FCF = EBITDA – CapEx – (changes in working capital)
CapEx
Because capital expenditures can weigh heavily on a company’s cash flow, CapEx requirements may have a dramatic impact on valuation.
Asset intensive businesses (construction companies, for example) often require large amounts of CapEx to sustain growth. The more CapEx required for growth, the less free cash flow available to the company, the lower the valuation and the lower the resulting EBITDA multiple.
Working Capital
Changes in working capital also affect free cash flow, but typically much less so than EBITDA and CapEx. There are certain cases where changes in working capital have a significant effect on cash flow – for example, in high growth companies that serve large corporations as customers. Sometimes these customers have a habit of stretching accounts receivables out 60 – 90 days. Because of the delay in receiving payment for work already performed, this growth, which is normally good, can tie up a lot of cash in the working capital of the company. Bummer.
The more working capital required for growth, the less cash flow available to the owner, the lower the valuation, the lower the resulting EBITDA multiple.
Companies are valued based on the present value of projected future cash flow. The value can then be stated as a multiple of cash flow but is often further abbreviated to a multiple of EBITDA. While not explicitly stated, the EBITDA multiple already includes the influence of CapEx and changes in working capital. This is one reason why different industries and even different companies within an industry can transact at such widely varying EBITDA multiples, even with the same growth projections.