Last month, my colleague Abed wrote an insightful blog about (alternative) valuation methods in the world of startups. In most cases, valuation methods for startups are not representative of the valuation of an average SME (Small and Medium-sized Enterprise). For SMEs, historical business results often provide an indication of expected revenues, which forms the basis for valuation.
As a specialist, multiple valuation methods can be used to determine the value of a business. Two financial metrics play a crucial role here: free cash flow (FCF) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), also known as operational profitability. Although both terms indicate a company's financial performance, they differ significantly in their content, purpose, and focus. To better understand these common terms in business valuations, I will provide some explanations.
Operational Profitability (EBITDA)
The EBITDA of an SME provides an indication of profitability from operational business activities. It shows what is earned from the core activities of the company. EBITDA does not take non-operational matters, such as the financing structure, into account. The significant advantage of this is that the profitability of companies and sectors can be compared well at the EBITDA level, regardless of the specific financing and investment decisions of the company.
Free Cash Flow (FCF)
A more complete picture of a company's profitability is offered by FCF. FCF is based on EBIT and also considers corporate taxes and changes in fixed assets and net working capital. Compared to EBITDA, FCF also accounts for necessary investments for future growth and tax payments. FCF provides a picture of the actual cash flows generated, after all expenses. It is up to the shareholder to decide whether to use FCF to pay interest, repay debt, or distribute dividends.
Conclusion
In summary, if we rely solely on EBITDA in business valuations, we miss important aspects such as future capital expenditures on assets or working capital and tax obligations, which can lead to a misjudgment of the company's value. However, EBITDA is valuable for easy and balanced comparison of different companies in the market. By understanding FCF, we get a more accurate picture of a company's ability to generate cash and create value in the long term. A good analysis of FCF enables the shareholder to make better decisions about growth, investments, financing, and value creation.
Therefore, it is important to evaluate both EBITDA and FCF during valuation. At Schuiteman M&A – Corporate Finance, we apply this approach by comparing our FCF-based Discounted Cash Flow (DCF) valuations with the EBITDA multiple valuation method. This provides a more complete picture of the business activities and value, aiding in well-informed investment decisions. It is important to note that the valuation outcome is not necessarily the market price. Many other factors also play a role. Hence, the art of business valuation is not an exact science.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.