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EBITDA and Fair Market Value

One of the main differences between the world of real life transactions and the fair market value world is the way that interest and taxes are taken into account in a valuation.

 

One of the key measures that is often used in mergers and acquisitions is EBITDA - earnings before interest, taxes and depreciation. In many cases, a multiple is applied to an enterprise's EBITDA to determine the price at which an offer is made for the business. In some respects it's a clean measure since it removes the idiosyncrasies of a company's debt levels and tax characteristics, and focuses on the cash generating ability of the company. This approach assumes that a buyer will not be bound by these details in the future, i.e. that a new capital structure will be put in place that may change interest payments and that the tax burden may also be affected by the buyer's tax planning decisions.

 

In the fair market value world under the income method of valuation we are also looking at the cash flow of a company, but we assume that the capital structure will remain in place. In valuing the company's equity we will, therefore, make sure that the cash flow we value takes into account interest and principal repayments on debt existing as of the Valuation Date.

 

We will also apply a tax burden to the after interest cash flow. The reason we do this is that the discount rates we use are derived from the public markets, which already reflect after-tax returns. If we applied these rates to the pre-tax cash flow of the subject company, we would be comparing apples to oranges. As a result we will often apply C corporation federal and state tax rates to reach an after tax cash flow.

 

This theoretical approach will often lead the fair market value of a company being significantly lower than a price that may be agreed in an arms-length acquisition transaction.