If you’re interested in selling your business, you may be doing some research on how businesses are valued.
There are lots of misleading theories out there about how to best value a business, including using a multiple of revenue (not good) or a multiple of net profit (even worse).
You may have run across these valuation methods in your research, but trust us, using them will generally result in an inaccurate valuation.
You may have heard of other valuation metrics as well, such as EBIT and EBITDA.
Both of these valuation metrics are used to value businesses with more than $1 million in earnings.
But what’s the difference between EBIT and EBITDA?
In this blog, we’ll define each of these valuation metrics, discuss their differences, and why each of them are used.
Let’s get to work.
What is EBITDA?
Before we discuss EBIT, it’s important for you to understand EBITDA.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
Using a multiple of EBITDA is the most common valuation method for businesses with over $1 million in earnings, as opposed to seller’s discretionary earnings (SDE) which is more common for businesses with less than $1 million in earnings.
EBITDA is a useful earnings metric to use when considering the historic performance of your business. Your business’s EBITDA is calculated by adding back certain expenses that won’t necessarily be the same for a new owner.
The formula used to calculate EBITDA looks like this:
- Net Income – Your net income is the starting point for determining your company’s EBITDA
- Interest – Since any business with debts to pay will have some interest expense, you may be wondering why this is added back. Adding back a business’s interest expense allows the new owner to choose if they’ll use debt to buy the business and negotiate their terms.
- Depreciation and Amortization – These add backs are helpful mainly for tax preparation. Depreciation and amortization are added back because they are non-cash deductions, and whoever buys your business will have their own depreciation and amortization schedules.
- Taxes – Even businesses similar in size and industry can be taxed differently. Adding back taxes allows this factor to be removed so that businesses are more comparable without their unique tax brackets and tax structures. Think of this as a way of comparing apples to apples.
To learn more about EBITDA, check out our blog “What Is EBITDA?” where we go into more detail and provide an example EBITDA valuation.
What is EBIT?
Now that you understand the EBITDA acronym, understanding EBIT will be much easier. As you might’ve guessed, EBIT is a valuation metric that starts with your business’s net income and only adds back interest and tax expenses. Using EBIT, depreciation and amortization expenses are not added back to your net income.
EBIT can be useful when determining a company’s operating profitability. Since depreciation and amortization aren’t cash expenses, keeping them as expenses in a valuation can help determine what a business generates from its operations.
So, when might you use EBIT instead of EBITDA?
EBIT vs EBITDA
Generally speaking, EBITDA is a far more common valuation metric than EBIT.
This is because EBIT is used in specific cases, the most common being when valuing an asset intensive company.
Asset intensive companies are companies that require above-average capital to operate. Think companies in which regularly purchasing new equipment is necessary to maintain a consistent revenue stream.
Over time in asset intensive companies, depreciation expenses can be a good measure of the actual amount of capital expenditure required to maintain (not grow) operations.
This is typically true in industries such as mining, oil and gas, and heavy construction.
Keep in mind, it isn’t always appropriate to use EBIT just because your company has high depreciation expenses.
For example, it may be necessary for Company A, who does heavy construction, to expense $100,000 dollars towards new equipment each year in order to keep a fully operational equipment fleet, and thus a consistent revenue stream.
This is different from Company B, who has expensed $100,000 per year over the last three years in an effort to grow an equipment fleet, and thus grow their business's earnings.
Since Company B is using the those expenses to grow the business rather maintain the current income stream, depreciation and amortization should be added back to the valuation, making EBITDA a more appropriate valuation metric for Company B, and EBIT a more appropriate valuation metric for Company A.
In short, if a company must consistently purchase depreciable assets in order to maintain a consistent revenue stream, EBIT can be a better valuation metric to use than EBITDA.
EBITDA and EBIT are both metrics that can be used to value companies with more than $1 million in earnings.
EBITDA is the more common metric between the two, but EBIT can be useful if you have an asset intensive business.
To learn more about how businesses are valued, check out our blogs “What Is a Business Valuation?” and “What Multiple Should You Use to Value Your Business?” where we discuss the best (and some of the worst) ways to value your business.
If you’re considering selling your business, but aren’t sure where to start, contact us today for a free business valuation. We’d love to learn more about your business and help you get started on the right path.