Why do PE firms use the EV/EBITDA multiple?
Hi @all,
I've a hard time understanding why EV/EBITDA is such a popular valuation multiple among PE firms. Why don't they just use OCF in order to come up with the actual cash power of the operating activities?
thanks & cheers!
EBITDA is capital structure and tax independent for one.
OCF takes out capex which is interesting, but that’s also why you see people look at multiples on EBITDA - capex for businesses where capex is notable.
It’s a good point though, OCF takes into account changes in working capital. Sometimes I’ve seen people do “cash adjusted EBITDA” where you take into account specific working capital line items, but never the whole mcgillicutty.
To answer your original question, main reason is that it’s convention and easy.
OCF does not account (take out) for capital expenditures
If you look at what you say from an accounting perspective, it is true that cash flow from operations in the cash flow statement does not account for capex.
However, when talking about valuation (and you will see some industries where OCF is a common valuation metric) it is usually defined as EBITDA - Capex
Operating cash flow includes interest expense. EBITDA is capital structure neutral
To be honest, in my experience (only like 6 months on the buyside lol) we don't really care about EV/EBITDA multiples except as a way to benchmark against other assets i.e. we are about to sell a portco in xyz sector and a similar asset just sold for 10x, so that's helpful info.
But it's not like we're doing valuation work based on multiples.. like we're not just going to say this type of company usually trades at 8x, so that's our bid. lol. Ultimately, what matters is the IRR we can achieve based on dividends and exit value. We won't even use EV/EBITDA as an exit assumption, instead we'll assume an IRR neutral buyer. It's bankers who loooove EV/EBITDA. When I was in banking we we're constantly showing every client versions of the same dumb bar chart multiples pages iykyk to compare how different subsectors were trading i.e. water utilities are trading at higher multiples than electric, etc.
But those slides are more useful to show to big public companies that are trying to position themselves to be valued optimally in the public markets. For example, an integrated company selling off a lower multiple division to "rebrand" themselves. In PE, we don't really care about that stuff as much. We ultimately just care about how much cash is coming out of the company.
What does “irr neutral” mean? Your post makes no sense. What pe firm are you working at?
Your first question was going to be my question as well
My guess is he's talking about doing a "next financial sponsor" analysis whereby the next buyer would need to achieve the same IRR as they model in their base case. i.e. If they underwrite to 20% IRR and assume a 5 year hold, they'll have years 5-10 in the model as well and have a separate "LBO" that shows the next financial sponsor can make 20% IRR in years 5-10. IMO this analysis is kind of a fools errand because 1) You still need to assume entry/exit EBITDA multiples in years 0, 5, and 10 and 2) your projections years 5-10 are almost certainly wrong, but it can sometimes be helpful to get comfortable with the price you're paying for an asset.
What everyone above said about it being a neutral metric is correct. But at the end of the day, you'll always end up using a metric more specific to the business you're looking at whether you're taking EBITDA-Capex or some adjustment of the sort - it's never just cut and dry.
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