We know that EBITDA (earnings before interest tax depreciation amortization) is a good indicator of a company’s operating performance. While net profit is the bottom line and shows, profitability, there are a lot of things that can go into that calculation that aren't necessarily related to a company’s operating performance.
Gross profit is just the opposite. It doesn’t show enough because it excludes other costs such as staff, rental, marketing, investments in expansion, equipment and machinery, etc. And it’s exactly these latter items where private equity comes into play and GPs can work with portfolio company management teams to implement changes and ultimately, create value.
What is EBITDA?
Earnings before interest, Taxes, depreciation and amortization (EBITDA) is an important metric to measure a company’s financial performance in terms of its operating income generation. It is calculated by first finding a company’s operating profit (EBIT) before subsequently removing the expenses garnered from depreciation and amortization. EBITDA can also be known as operating profit, and It’s the right measure to use in private equity.
Why is EBITDA Important in Private Equity?
Private equity is about value creation, which is done by implementing changes to improve top-line revenue (e.g. growth and expansion into other markets) and operating efficiency (e.g. changing manufacturing processes or using high tech machines). It’s about making a company much better than it was before. All of these will impact EBITDA.
Private equity is unlike publicly listed equities where the value of a listed company is essentially determined by its stock trading price. To calculate the value of a private company where there is no trading stock price, we use multiples of EBITDA.
Early-stage and venture capital-backed private companies also don’t have a trading stock price, but they are not valued based on EBITDA because they probably aren’t yet generating an operating profit. These private companies are usually valued based on the last financing round or by using DCF — discounted cash flow. For example, a private company would be valued at 7 times its EBITDA and so if its LTM EBITDA is $50m, then the company’s value would be $350m.
These multiples of EBITDA are commonly referred to as “EBITDA multiple” or “Entry EBITDA multiple” or generically as “pricing multiple.” Private companies can also be valued using other metrics such as price-earnings (P/E) ratios). It’s with these multiples that investors compare the pricing of private companies.
For example, if mid-market private companies in the US healthcare services segment are trading at 6.5x EBITDA and one of your GPs recently invested in a company in this space at 9x EBITDA, then you can see that this GP paid a much higher valuation compared to the market price.
Used to indicate a private company's debt loan
EBITDA is an important metric in private equity because it’s also used to indicate a private company’s debt load. As a reminder, the “B” and “I” in EBITDA stand for “before interest”, so the liquidity to service debt obligations comes from EBITDA.
In simplistic terms, if EBITDA is too low or negative, then the company can’t service its loans. To gauge a private company’s debt load and its ability to service that debt, we use debt ratios as one indicator of the company’s health or risk.
For example, a company could have total debt in the amount of 5x EBITDA (if the company is generating $100m of EBITDA, then that’s $500m of total debt) and if you benchmark that against industry peers that are loaded with debt at 3x EBITDA, then that gives you an indication of risk at this company.
EBITDA and CEPRES
Now that we’ve established the importance of EBITDA in the context of private equity and how it actually comes into play in the private equity asset class, how can GPs and LPs actually analyze it and the metrics described above?
CEPRES is an award-winning private equity database and technology platform that includes all of the EBITDA analytics described above within its operating analysis module. Individual components within this module include value creation, pricing multiples and debt multiples (financing structure).
Not only is it possible to analyze EBITDA for your own portfolio of private equity investments, but most importantly, you can benchmark and compare your EBITDA metrics against comparable peers in the market which you can specifically define and carve out.
Now that is powerful and smart. That’s CEPRES!
Want to know more and what you can discover in CEPRES? Then reach out.hat is