EBITDA Multiples and Yield: Better Understanding Private Market Valuations

Understanding how EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiples and yield relate to the valuation of private companies is essential for business owners and investors. In this discussion, I’ll explain the relationship between EBITDA multiples and yield, provide historical context, and compare private market valuations to public securities. This will offer a comprehensive framework for accurately valuing private companies and making informed investment decisions.

EBITDA & Yield Interconnection

Setting the Context

In previous discussions, we’ve explored EBITDA’s role in assessing a company’s pre-tax cash flow and its adjustments to provide a clearer financial picture. Today, we’ll delve deeper into how EBITDA multiples and yield interconnect, clarifying how these concepts apply to private market valuations.

Bridging EBITDA Multiples and Yield

EBITDA multiples are a fundamental metric in valuing private companies. When someone acquires a business, they often pay a multiple of its EBITDA. For example, a business sold for five times its EBITDA implies a 20% yield (1 divided by 5). This relationship highlights that EBITDA multiples can be viewed as the inverse of the yield required to justify the risk of the investment.

Risk-Adjusted Returns

The concept of risk-adjusted return is crucial in understanding EBITDA multiples. If Treasury bonds provide a 4.8% yield, and a business is sold for five times EBITDA, the implied return is 20%. This implies that the investor is demanding a 15.2% premium over the risk-free rate (20% – 4.8%) to compensate for the additional risk of acquiring the private business. Historically, private equity returns have decreased from 30-40% in the 1980s to 15-20% today due to increased market efficiency and competition.

Application & Relative Perspective

Practical Application

To illustrate, consider a business generating two to three million dollars in EBITDA. Depending on its size and perceived risk, it might attract different multiples. Smaller businesses typically require higher returns to justify the investment, leading to higher EBITDA multiples. This is because the risk associated with smaller companies is generally greater, necessitating a higher return to attract investors.

Market Comparisons

Comparing the valuation of private companies to publicly traded ones can provide valuable insights. Publicly traded companies often have lower yields due to their perceived lower risk and greater market efficiency. For instance, if a publicly traded company’s price-to-earnings (P/E) ratio implies a 6% return, a private business generating similar earnings might require a higher yield to account for its higher risk.

Yield and Risk-Free Rate

Yield, a key financial metric, helps investors evaluate the required return on private investments. By comparing the implied yield from an EBITDA multiple with the risk-free rate (e.g., Treasury bonds), investors can determine the risk premium necessary to justify the investment. For instance, if Treasury bonds yield 4%, and a private business acquisition implies a 20% return, the risk premium is 16%.

Public vs. Private Market Valuations

Public market valuations often reflect lower yields due to the lower perceived risk and higher liquidity of publicly traded companies. In contrast, private companies require higher yields to compensate for their higher risk and illiquidity. This comparison underscores the importance of understanding market context when evaluating investment opportunities.

Summary and Takeaways

Understanding the inverse relationship between EBITDA multiples and yield is essential for accurately valuing private companies. This relationship highlights the importance of risk-adjusted returns and the necessity of higher yields to compensate for the increased risk of private investments. By comparing private and public market valuations, investors can better contextualize their investment decisions and expectations.

While this topic might not be the most exciting, it’s crucial for anyone involved in valuing or investing in private companies. By grasping the relationship between EBITDA multiples and yield, investors and business owners can make more informed decisions, leading to better investment outcomes.