Why Two Companies With the Same EBITDA Can Have Different Valuations

EBITDA is often used to determine the valuation of a business. But it is not all that matters when it comes to business valuations.

Let us consider two firms:

Everything about the two companies looks the same. They earn Rs. 200 Cr each in revenues, and Rs. 30 Cr in EBITDA but still there is a Rs. 210 Cr difference in their enterprise value.

The explanation for this is rather straightforward: when buying a firm, buyers pay not only for the current EBITDA it generates but also for its quality and sustainability.

They look at a broader level on how it grows, how diversified it is in terms of its customers, how cash-generative it is, its competitive advantage, management team strength, and risk profile. That is especially relevant when a business prepares itself for acquisition, raising funds, or making investments.

So the question that needs to be asked is not only "What EBITDA does the business generate?" but also "How sure is a buyer that this EBITDA is going to be generated in the future?"

What Actually Drives the Valuation Multiple?

A valuation multiple is never an arbitrary number. A multiple depends on how the buyer sees and values the business and its future.

Two businesses can have identical EBITDA multiples but differ in their growth rate, revenue predictability, profitability or business risk and accordingly the buyer may assign different multiples depending on those criteria.

To put it simply for understanding, four general criteria can be stated that drive the valuation multiple:

• Growth: How fast can the business grow given its current size?

• Quality: How consistent and predictable is its revenue and earnings?

• Cash generation: How much of its earnings actually materialize as cash?

• Risk and strategic value: How strong is its competitive position and the risk associated with running the business? What strategic value it might have to a particular buyer?

The four criteria mentioned above are correlated with each other. An enterprise with higher growth potential, earnings quality, stronger cash conversion and competitive position will generally attract more buyers attention than an identical enterprise with worse criteria despite having the same EBITDA.

That is why the improvement of the multiple is not just about increasing EBITDA.

A. Growth and Earnings Visibility

A buyer is ultimately paying for the future earnings of a business. This is why growth matters, but the quality and visibility of that growth matter just as much.

Consider two companies, both generating Rs. 30 Cr of EBITDA. One has grown EBITDA steadily from Rs. 15 Cr over three years and has a strong order pipeline. The other has reached the same EBITDA largely through a recent price increase and a few large orders.

The current EBITDA is the same. The visibility of future earnings is not.

A buyer will therefore look at:

• Consistency: Is growth sustained across revenue, EBITDA and margins?

• Source: Is it organic, acquisition-led or driven by temporary factors?

• Visibility: Is there recurring revenue, contracted business or a credible pipeline?

• Scalability: Can the company grow without a similar increase in costs and capital requirements?

The key question is not simply “How fast has the company grown?” but “How repeatable is that growth?”

A more predictable earnings trajectory can give a buyer greater confidence in future performance and support the case for a stronger valuation multiple.

B. Quality of Earnings and Cash Generation

Reported EBITDA is not always the same as the earnings a buyer is prepared to underwrite.

As part of a transaction, buyers typically review the accounts for one-off income or expenses, related-party transactions, promoter-specific costs and other items that may not continue after the transaction. This can result in a normalised EBITDA that differs from the reported figure.

For example, a company reporting Rs. 30 Cr of EBITDA may have Rs. 3 Cr of one-time expenses and Rs. 1 Cr of non-recurring income, resulting in normalised EBITDA of ?32 Cr. Therefore, it could drive a higher valuation.

Further to it, even normalised EBITDA does not tell the complete story. Buyers also examine how much of that EBITDA actually becomes cash.

Key considerations include:

• Working capital: How much cash is tied up in receivables and inventory?

• Capex: How much needs to be reinvested to maintain and grow the business?

• Cash conversion: How consistently does EBITDA translate into free cash flow?

• Earnings quality: How much of EBITDA is recurring and sustainable?

Two companies generating Rs. 30 Cr of EBITDA can therefore have very different cash profiles. A business that requires substantial working capital and recurring capex may generate far less free cash than one with similar EBITDA but stronger cash conversion.

The buyer is not only assessing how much the business earns, but how much of those earnings can be relied upon and ultimately converted into cash.

C. Competitive Position, Risk and Strategic Value

The final question is how well the business can protect its future earnings.

Buyers will consider factors such as:

• Customer concentration: Is revenue dependent on a small number of customers?

• Promoter dependency: Can the business operate effectively without the promoter being involved in every key relationship or decision?

• Competitive position: Does the company have a brand, technology, distribution network, customer relationships or other barriers that protect its market position?

• Industry risk: How exposed is the business to competition, regulation or changes in demand?

These factors influence the level of risk a buyer associates with future earnings.

In M&A, there is also the question of strategic value. A strategic buyer may see benefits that are not reflected in the target's standalone financials such as access to customers, distribution, technology, manufacturing capacity, new markets or potential cost and revenue synergies.

This is why the same business can have different value to different buyers. The relevant question is not only “What is the company worth?” but also “Which buyers have a strong rationale for owning it?” 

From EBITDA to Equity Value

Once the buyer has evaluated the business and has decided the EBITDA multiple, the next logical step would be to value the business using the EBITDA multiple arrived at above.

It is quite simple:

Enterprise Value = Normalised EBITDA × EBITDA Multiple

For instance, if the normalised EBITDA is Rs. 32 Cr and the EBITDA multiple is agreed to be 10x, then the implied Enterprise Value works out to Rs. 320 Cr.

But this is not necessarily the amount which the shareholders will get.

The buyer has to consider the debt, cash and other agreed adjustments to the balance sheet.

Equity Value = Enterprise Value – Net Debt

In other words, if the business has an Enterprise Value of Rs. 320 Cr and net debt of Rs. 70 Cr, the implied Equity Value works out to Rs. 250 Cr.

This is an important point to remember in an M&A transaction as valuation discussions generally revolve around the Enterprise Value but the actual amount which shareholders will get will depend on the transaction adjustments agreed.

Thus, the multiple is just one aspect of the entire valuation process. The quality of EBITDA determines the earnings base, the nature of the business determines the multiple and the balance sheet determines the amount which shareholders will get.

What Can a Promoter Do to Improve Valuation?

Since value can depend on factors other than EBITDA, improving EBITDA is not the only option to increase the value of a business.

The list of key ways to improve business ahead of time can be very useful for a business promoter who intends to sell his business, raise capital or invest in his business strategically.

• Increase quality of growth: Create a more predictable basis for income, decrease reliance on one-offs business and create a clear vision of growth through customers, products or markets.
• Decrease customer concentration: If the business depends too much on a couple of customers, it poses extra risks to the transaction process. It will make future income easier to underwrite.
• Improve cash conversion: Even high EBITDA does not guarantee good cash flow. More control over receivables, inventory, working capital and capital expenditure will help the business.
• Low promoter dependency: Good business processes, professionalism of management and second-line employees make a business more transferable.
• Due diligence readiness: Clean financial documents, proper classification of one-off income, correct documentation of agreements and support of normalized EBITDA will prevent any unpleasant surprises in the process of the transaction.

These factors will not guarantee a higher valuation of the business, but they will increase the quality of a business and give the buyer a reason to believe in its future income.

What the Multiple Really Represents

The multiple is ultimately a price attached to uncertainty.

A buyer paying 8x EBITDA is making a different assessment of the future than a buyer paying 15x. The difference may have little to do with the EBITDA itself and much more to do with the visibility of that EBITDA, the risks attached to it and the opportunities that may sit beyond it.

This is also why valuation is not created at the point of sale. The factors that influence the multiple—customer relationships, recurring business, margins, cash generation, management depth and competitive position—are built over time and become visible during due diligence.

For a promoter, the real objective is therefore not to engineer a higher multiple, but to work with professional consultants and build a business that gives a buyer fewer reasons to discount it.