What is Adjusted EBITDA Margin?
The Adjusted EBITDA Margin measures the core operating profitability of a company on a normalized basis, i.e. inclusive of only items related to core business activities.
How to Calculate Adjusted EBITDA Margin?
- Adjusted EBITDA → The adjusted EBITDA metric is a non-GAAP, yet widely used, measure of profitability and operating performance of a company.
- Net Revenue → The revenue of a company refers to the total monetary value generated by a company from its operating activities, i.e. the sale of products and services, net of any discounts, refunds, and sales allowances.
At the most basic level, the traditional calculation of EBITDA comprises adding depreciation and amortization to EBIT, otherwise known as “operating income”. D&A is an add-back to the cash flow statement, as well as for free cash flow calculations (e.g. FCFF, FCFE), since no actual movement of cash occurred.
The movement from EBITDA to adjusted EBITDA is where most discrepancies and differences in opinion arise.
EBITDA is a non-GAAP metric, so the adjusted EBITDA metric expands the room for management discretion (and the risk of inflated earnings) even further.
Adjusted EBITDA Margin Formula
The formula to calculate the adjusted EBITDA margin is as follows.
- EBIT = Gross Profit – Operating Expenses
- D&A = Depreciation + Amortization
There is no standardized approach to calculating the adjusted EBITDA metric, which is the source of much criticism, as mentioned earlier.
What are Examples of Normalizing Adjustments to EBITDA?
In general, the most commonly accepted add-backs with relatively minimal push-back are the following:
- Owner Salary and Benefits → The salary earned by the management team pre-acquisition—even if the same management continues to run the company—might be adjusted downward to be closer to the market rate. Therefore, the “excess” compensation and benefits are removed to more accurately portray the financial state of the company post-acquisition (or integration if the acquirer is a strategic buyer rather than a financial buyer).
- Owner Expenses: If the management team spent company funds to cover personal expenses and one-time events, those expenses could be added back. However, the assumption here is that those expenses will not continue in the foreseeable future, i.e. they are one-time events.
- Rent: The company might currently be paying less than or above the standard market rent, which could warrant an adjustment to its fair value for bookkeeping purposes. In other words, historical rent prices can be adjusted to be closer to the current market rate.
- Understaffing: The new owner might identify gaps in the company’s employee base. The issue of understaffing is that it is more subjective, which makes it more challenging to negotiate. In fact, the acquirer would likely need a valid case that the understaffing was either deliberate to reduce spending and improve profit margins or was the result of poor management decisions (i.e. relative to the norm among industry comparables).
- One-Time Fees: Usually, the fees paid to third parties, such as lawyers, consultants, and investment banks—assuming that such services received are one-time expenses—are added back to EBITDA.
- Asset Impairment: If the fair value of an asset, such as inventory or PP&E, declines below the value recorded for bookkeeping purposes, the company can write down the value to more accurately reflect the current value of the asset. Alternatively, if the fair value is zero (i.e. accidental fire-damaged inventory), the value of the asset must be subsequently written-off to provide the highest level of transparency to investors and the general public.
How to Analyze Adjusted EBITDA Margin in M&A?
The adjusted EBITDA metric is most prevalent in M&A, although public companies have increasingly started to present their own non-GAAP metrics, such as in press releases and earnings reports.
Because EBITDA is independent of the capital structure (i.e. discretionary financing decisions) and hones in on the core operations of the company, the metric is widely used by equity analysts and investors, both on the retail and institutional side.
In theory, the adjustments offer more transparency to the investor (or acquirer) and portray the true financial state of the company. The problem that emerges, however, is determining which items qualify as an adjustment and which criteria to apply.
Once past the letter of intent (LOI) stage, a significant portion of the diligence conducted by the acquirer (or team of M&A advisors) is to verify each of the adjustments made to EBITDA and to ensure no material item was missed, followed by further negotiations with the seller and the sell-side advisor.
Adjusted EBITDA Margin Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Operating Assumptions
Suppose you’re tasked with calculating the adjusted EBITDA of Twitter in Q-2 of 2022, before the social media company underwent a privatization.
The financial data that we’ll use in our exercise are as follows.
|Selected Financial Data ($ in 000s)
|Net Income / (Loss)
|Depreciation and Amortization (D&A)
|Interest and Other Expense / (Income)
While not recommended on the job, we’ll be taking Twitter’s internal adjustments at face value, for the sake of time.
2. Adjusted EBITDA Calculation Example
Starting from net income, we’ll make a total of four adjustments.
- Stock-Based Compensation → The treatment of stock-based compensation is rather intricate, with numerous conflicting views. While stock-based compensation might not represent an outflow of cash, there can be implications on the per-share valuation of a company due to the dilutive impact of such issuances, which can become quite substantial for certain companies. Here, Twitter has decided to add the non-cash equity compensation in their calculation of adjusted EBITDA.
- Depreciation and Amortization (D&A) → D&A is a non-cash expense and is thus added back on the cash flow statement (CFS). Unlike most expenses recorded on the income statement, D&A is not an actual outflow of cash. Instead, D&A is recognized as an accounting convention required under accrual accounting guidelines, in which the purchase of long-term assets must be capitalized and expensed over its useful life assumption.
- Interest and Other Expense / (Income) → The interest and other expense / (income) section is the section beneath the operating income line item on the income statement. Items like interest expense or interest income are non-operating items, i.e. not integral to the core business activities of the company and generation of future revenue.
- Income Taxes → Like interest, the income taxes paid to the local, state, and federal governments are a non-core item unrelated to operations.
Once the four adjustments are made, we’re left with an adjusted EBITDA of $111.7 million, which is equivalent to the reported amount in Twitter’s Q2-22 filing.
3. Adjusted EBITDA Margin Calculation Example
In the final part of our exercise, we’ll calculate Twitter’s adjusted EBITDA margin in Q2-2022.
Since we have the two required inputs—adjusted EBITDA and revenue—we can enter them into our formula from earlier to arrive at an adjusted EBITDA margin of 9.5%.
- Adjusted EBITDA Margin (%) = $111,705k ÷ $1,176,660k = 9.5%