Will we ever see a normal level of normalised EBITDA?

What is EBITDA/normalised EBITDA?

EBITDA is a key measure of business performance and a well-established cornerstone of transaction valuations. It is viewed as a proxy for operating cash flow, to which a multiple is applied to arrive at the enterprise value of a business. In a financial diligence process, much of my focus tends to be on assessing normalised EBITDA.

EBITDA stands for Earnings (i.e., operating profit) before Interest, Taxes, Depreciation, and Amortisation. By excluding interest, taxes, depreciation, and amortisation from the earnings, EBITDA provides a clearer picture of a company's operational profitability and its ability to generate cash flow from core business activities.

The use of a normalised or adjusted EBITDA measure seeks to adjust for the impact of a non-recurring event or a permanent change in a business to establish a robust basis for assessing ongoing trading.

Is anyone still talking about EBITDAC?

In 2020, a new twist on the term emerged, “EBITDAC”, meaning earnings before Interest, Taxes, Depreciation, Amortisation and Coronavirus.

The impact of the pandemic was felt mainly in 2020 and 2021, and companies have had plenty of other things to deal with since then. As such investors are not using EBITDAC as a valuation metric but how a business performed in this period is being used by investors to inform their assessment of how businesses and management teams might perform during a downturn.

What is normal for EBITDA now?

The most common adjustments we see depend on the nature of the business. Founder owned and managed businesses often adjust for ‘lifestyle costs’ such as expenses that a different owner might not incur and a payroll that might not reflect arm’s length remuneration. A private equity backed business might adjust for cost investments that are not yet mature in delivering their impact.

During the peak of the post-COVID-19 M&A boom, the list add-backs to EBITDA expanded - a higher level of EBITDA can justify a higher valuation and win a deal. We saw planned price rises and cost savings being suggested as adjustments. However, buyers are currently being sceptical in the more uncertain environment.

To assess normalised EBITDA, we tend to take a more sophisticated approach. So, as well as historical, normalised EBITDA, we typically look at:

Projections

If future revenue is visible and there is clarity of the cost base then analysis of projected performance might be helpful. However, evidencing the future is difficult at the best of times. for many businesses, there is still uncertainty around geo-politics, supply chains, borrowing costs and inflation. This is why building resilience into your business is so important.      

Run rates

Annualising a recent period such as the last three months or a highly visible future period by incorporating an order book or pipeline can be informative as long as you remember to factor in seasonality.

Cash costs missing from EBITDA

Capital expenditure should always be considered. It is subject to accounting policy choices such as whether to capitalise development costs and lease accounting, so we look through the accounting to get to the underlying cash cost of maintaining EBITDA.

Conclusion

Identifying reasonable adjustments to EBITDA is highly judgemental, with sector and deal experience critical to the assessment of potential adjustments. The same applies to adjustments to the equity value of a business: the enterprise value, plus cash, less debt, assuming a normal level of working capital.

The question of what the normal level of EBITDA is continues to evolve and there is no doubt that it needs careful consideration, by both buyers and sellers alike.