EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization and, since the 1980’s, it has become erroneously synonymous with value, profitability and cash flow.
The value of EBITDA is that it can measure Operating Profitability of a company by eliminating the effects of financing and accounting decisions. It will tell you if you can make money on the revenues you are generating less the expenses that you incur to operate your business. So heavy or light taxation and good or bad decisions regarding the value of acquisitions and the cost of debt are purified from your profitability as an insurance agency.
But why has EBITDA become a popular measure of value in agencies and other businesses? It was never developed as a measure of value. In the 80’s the leveraged buyouts of the tech industry required a medium that would express some measure to differentiate valuable leveraged companies from companies that showed no value because they were simply poorly operated. Neither showed profit, but the valuable, leveraged companies could be shown to be potentially profitable using the EBITDA while the valueless poorly managed companies would reflect little worth with or without the measures of EBITDA.
So EBITDA provided a measure of profitability but was never meant to be the final arbiter of historical or projected profitability nor is it equal to Cash Flow, the measure of whether you can financially benefit from your insurance operation over the long term. It is certainly NOT a measure of cash flow since critical components of EBITDA (taxes and interest) are cash items that MUST be paid regularly to permit your business to continue.
The value of a business still depends primarily on the earnings (after tax) potential of that business to whoever is doing the valuation over an acceptable period of time. Cash flow becomes a component of value since Depreciation and Amortization (a subtraction from taxable income) are non-cash items that could be recovered in addition to earnings to finalize the full economic benefit that can arise from the value of your or someone else’s agency.
We have no problem with showing EBITDA as a proper measure of economic viability in the many valuations we do each year. However, we don’t (and won’t) express value as a multiple of EBITDA just as we don’t express value as a multiple of revenues, earnings or any other measurable item that is present in an insurance agency. EBITDA used to value a business is the worst form of VALUATION VOODOO. The appraiser has taken a perfectly good profitability measure and has created a “monster” that professional’s and amateur appraisers continue to use to evolve a value to a business like an agency. EBITDA can no more likely be used to express value than could multiplying a dollar amount by the number of chairs in the office to express the agency’s value.
If you understand the concept of EBITDA and its rightful use to analyze operating profitability it regains its value in agency analysis. But please don’t be drawn into the Valuation Voodoo by trying to caste an EBITDA calculation and then multiplying it by some multiple as an indicator of agency value.