No matter whom you speak with about private company acquisitions, from accountants to lawyers to business owners, it seems everyone today measures purchase price as a multiple of EBITDA (Earning before Interest, Taxes, Depreciation & Amortization). Too often, those involved choose to use metrics that the market wants to “talk about“, rather than metrics that are practical.
The measure that most businesses (and purchasers) are concerned with is actually free-cash-flow. Free-cash-flow is the amount of cash that a company has justify over after it has paid all of its expenses, including capital re-investment. The most accepted measure of free-cash-flow is EBITDA less Capital Expenditures (EBITDA-CAPEX), not EBITDA.
It is important to understand what specific free-cash-flow measurement to use when comparing different companies. Service companies normally require very little capital reinvestment, and as such, EBIT (Earning before Interest & Taxes) is an appropriate cash flow metric. For capital intensive businesses, EBITDA-CAPEX is more appropriate, since it accounts for the necessary capital reinvestment to maintain and/or grow the business.
No matter what EBITDA Purchase Multiple was paid for a company, it may have little to do with a company’s free-cash-flow, which is the most important metric when buying a company!
This article was written by Ron Dersch and was published in the March, 2006 issue of M&A Today.