When selling a dealership, establishing an appropriate valuation for it is a key part of the process. But when buyers are looking at other dealerships that may be on the market at the same time as yours, they may come across a wide variety of different financial structures, taxation rates, and methods of depreciation.
EBITDA provides a clear way for buyers to evaluate all of these potential candidates on an equal footing, so that they can make an apples-to-apples decision about which dealership offers the best return on their investment for the price being asked.
Let’s take an in-depth look at what EBITDA is, how it came about, how EBITDA is used to value a business, its benefits, and its drawbacks. We’ll finish up by answering the question of whether your EBITDA can be too high, and what that means to potential acquirers of your dealership.
What is EBITDA?
EBITDA is a financial calculation that is explained by the acronym that describes it:
Earnings Before Interest, Taxes, Depreciation & Amortization
Let’s define each of these items:
Earnings: This is established by starting with your total revenue, then deducting your operating expenses (which make up the acronym’s “ITDA”). It is also known as net income.
Interest: This is what it costs you to service your debt, but the amount is not subtracted from EBITDA
Taxes: While you cannot avoid paying taxes, they are not subtracted from EBITDA
Depreciation: This is the loss in value over time of your tangible assets, and it is not figured into EBITDA
Amortization: This relates to any intangible assets that the business owns, such as patents or copyrights, that will eventually expire and lose all value. This is also not a component of the EBITDA calculation.
Here is a simple equation that will let you calculate your dealership’s EBITDA:
Earnings + Interest + Taxes + Depreciation + Amortization = EBITDA
Where did EBITDA come from?
EBITDA first came into use in the 1980s, during the age of leveraged buyouts (LBOs). Investors who were evaluating distressed companies that needed to be restructured began using EBITDA as a way to determine whether these companies would be able to service their heavier post-restructuring debt load over the next year or so. Since then, EBITDA has become a more common technique used in valuations before a business is bought or sold.
How is EBITDA used to value a business?
The proponents of EBITDA see it as a way to “level the playing field” when comparing businesses in the same industry. By stripping out different debt structures, tax rates, and varied ways of accounting for depreciation and amortization, the true value of a company’s ability to generate earnings is revealed. This EBITDA-based value can then be compared to any other similar business.
Valuations of businesses like auto dealerships are typically based on a multiple of EBITDA. All things being equal, a higher EBITDA should translate to a higher dealership value and a higher selling price. Of course, there will normally be some negotiation between buyer and seller as to the final figure.
What are the benefits of using EBITDA?
EBITDA has become a widely-used metric for valuing a business, and has certain benefits:
- It focuses on a business’ operating performance.
- It gets rid of variables that are unique to each business.
- It is a good indicator of a company’s financial soundness.
- It is simple to calculate and is easy to understand.
- All of its elements are easily accessible from a company’s financial statements.
- It shows growth potential.
- It shows the strength of cash flow from ongoing operations.
What are the drawbacks of using EBITDA?
While EBITDA may be good for some aspects of business valuation, it excludes many expenses and is not a substitute for comprehensive due diligence:
- EBITDA is not a true measure of cash flow (taxes and interest must still be paid).
- Depreciation and amortization are not avoidable; equipment wears out and needs replacing, while copyrights and patents eventually expire.
- Accounting problems on the income statement can make the earnings figure used for EBITDA unreliable.
- Eliminating interest can make a company look more profitable than it actually is.
- EBITDA may result in a lower valuation than when estimated net income or operating profits are used – other price multiples should also be considered.
- EBITDA assumes that all revenues will be collected.
- EBITDA can hide some serious financial problems.
- EBITDA is not defined in GAAP, so should not be relied on to the exclusion of other approved methods.
- EBITDA can be manipulated to produce fraudulent results (see WorldCom and Waste Management for examples of this!).
Can your EBITDA be too high?
On its face, your dealership’s high EBITDA can indicate that it is financially healthy, is highly profitable, and can manage its debt very well. So far, so good. But if your EBITDA is unusually high, then that can be too much of a good thing.
What message does a high EBITDA send to potential acquirers?
A really high EBITDA, one that is much higher than other comparable dealerships that are also for sale, could cause you problems. A too-high EBITDA could translate to a very high sales price that makes your business unattractive or uncompetitive. This could price you out of the market and make other dealerships, with their lower EBITDAs and lower sales prices, look like better values as acquisitions.
If you are a private company that does not necessarily follow GAAP for depreciation or amortization, a too-high EBITDA could also be a red flag that invites scrutiny of your financial and accounting practices. Are you recognizing revenue properly? Are you understating expenses? Are you capitalizing instead of expensing? If you have a high EBITDA, you need to be able to justify it on all these accounts.
DCG Acquisitions is here for your dealership buy or sell transaction
For EBITDA issues, as well as everything else involved in selling or buying a dealership, DCG Acquisitions is here for you. We are one of the country’s leading, and fastest-growing, automotive M&A firms, backed by a network of connections — including automotive manufacturers, financial lenders, dealership buyers and sellers, and more — that help us create a qualified, competitive environment on both sides of the sale.
Contact DCG Acquisitions to speak directly with an Automotive M&A specialist and learn how our expertise can help you get the most out of your next dealership purchase or sale.