Should you use 12-month EBITDA or a 3-year average when valuing a company?
A market comparable approach to value usually involves looking at what similar businesses have sold for as a multiple of some measurement of financial performance like revenue or earnings before interest taxes depreciation and amortization (EBITDA), and then applying that multiplier to the financial measurement of the company whose value is being estimated. For example, if the average sold comparable had $1 million in EBITDA and sold for $10 million, the business is said to have sold for 10x EBITDA, and if a business being valued had $700,000 in EBITDA then the estimate of value would be $7 million ($700k x 10).
I see some buyers and their business brokers make a mistake in the application of this estimate of value, in a way that undervalues a business. Here's what happens: the business being valued has had strong growth over the past three years, so the business broker estimating value decides to average the past three years EBITDA, and then they apply the multiplier to that average.
The problem with this is that unless the business broker also uses a three-year average of each sold comparable business' EBITDA it results in an apples-to-oranges comparison. Most often when you can locate sold business comparable data from sold business databases you only see the most recent 12 months of financial data. So, for example, if a business had $1 million in EBITDA and sold for $10 million, the EBITDA multiplier would be 10. However, if that business had been growing at a 15% annual growth rate for the prior three years then the average three-year EBITDA would have been $875,236, not $1 million. If you divide the $10 million price by the three-year average EBITDA you would actually get an 11.43 multiplier, not a 10x.
So generally, when using a multiplier, business brokers should be applying it to the most recent 12 months financial data, not a multi-year average.