What is Normalized EBITDA?
Normalized EBITDA measures the operating cash flow generated by a company’s core business activities with discretionary adjustments to remove the effects of non-recurring items and irregular events (i.e. one-time).
How to Calculate Normalized EBITDA?
The simplest calculation of EBITDA—i.e. the sum between EBIT and D&A—is an estimate of the operating cash flows produced by a company’s day-to-day business functions.
Neither depreciation nor amortization represent an actual movement of cash. Instead, the recognition of the depreciation and amortization expense on the income statement is related to accounting conventions and the strict guidelines established under U.S. GAAP reporting standards.
EBITDA is one of the most practical metrics, particularly in the context of M&A and valuation, which is attributable to the following characteristics.
- Core Operating Performance (i.e. Unaffected by Non-Core Items)
- Non-Cash Adjustments (e.g. Depreciation and Amortization)
- Capital Structure Independent (i.e. Neglect Interest Expense)
- Representative of All Capital Providers (e.g. Debt, Preferred Stock, Common Equity)
- Pre-Tax Profit Metric and Unaffected by Taxation Differences by Jurisdiction
- GAAP to Non-GAAP Adjustments (i.e. Reconciliation of Cash)
In recent times, however, the usage of the EBITDA metric has increasingly come under more criticism, which coincides with the emergence of “Adjusted EBITDA”.
Because EBITDA is a non-GAAP profit metric—i.e. there is no dedicated line item on the income statement—companies and their management team have more discretion in terms of what truly constitutes an add-back.
The adjustments applied to EBITDA are necessary to reflect the true operating performance of the company, which typically guides the offer price in M&A and the fair market value (FMV) of a company’s shares in the open markets if it is publicly traded.
The vast majority of M&A transactions, if not all, tend to hold lengthy negotiations specifically to discuss EBITDA — or more specifically, the validity of the adjustments made to EBITDA.
Normalized EBITDA Formula
The formula to calculate normalized EBITDA is as follows.
The most common examples of adjustments, aside from the add-back of depreciation and amortization, are listed in the next section.
Normalized EBITDA: Examples of Adjustments
- Owner Salary → If the historical salary earned by the owner is higher than the market rate, an add-back can be necessary, since salary will eventually converge closer to the industry norm post-acquisition rather than the outsized payments.
- Family Member Wages and Benefits → While the family members of the owner might remain with the company post-buyout, their wages and benefits received must be objectively evaluated, i.e. the new owner must ensure the family members were not taking advantage of the company.
- Owner Expenses → For small to mid-sized businesses, the owner will often use their company funds to pay for personal expenses, such as vehicles, entertainment, and attendance of networking events. While the spending can certainly benefit the company, by no means are these expenses integral to the continued stability and operations of the company.
- Rental Expense → The company might pay above, near, or below standard market rent prices, which would warrant an adjustment to its fair value on the financial statements, i.e. the rent expense is adjusted to be near the fair market value (FMV).
- Management Team → Contrary to the owner salary adjustment, where the owner earned an above-market salary, the acquirer might identify gaps in the company’s employee base. In that case, new roles would need to be hired post-buyout, which directly increases the need for spending (and a downward adjustment to EBITDA related to incremental wages and new employee training).
- One-Time Fees → Certain fees such as those incurred from hiring a third-party professional, such as litigation fees owed to lawyers or the fees paid to an investment bank for its services related to M&A or capital raising advisory, are treated as add-backs in the normalized EBITDA calculation. For example, a company’s legal fees are recognized on the income statement and reduce net income (i.e. the “bottom line”). Nonetheless, such extraordinary items are not considered to be part of the company’s core business operations, i.e. they are non-recurring, one-time events.
- Asset Write-Down or Write-Off → The recorded value of an asset can lose significant value relative to its book value. Companies tend to be hesitant to complete a write-down or write-off because it suggests mistakes were made. However, the write-down or write-off of inventory (or a fixed asset and goodwill) is necessary to provide full transparency to investors.
- Restructuring → The process of undergoing a restructuring—whether it is a complete reorganization (i.e. Chapter 11 In-Court bankruptcy) or operational restructuring—can become very costly for the company.
Normalized EBITDA in M&A: Purchase Multiple
Considering most purchase multiples in M&A are based on trailing EBITDA, adjustments can have a material impact on the implied valuation. Therefore, it is a critical step in the diligence stage to closely examine and question the proposed add-backs to develop a better understanding of the company (and ensure the financial state of the company is not misconstrued).
Similar to operating income (EBIT), EBITDA is frequently used by equity analysts and investors—ranging from the retail market to institutional investors—to compare peer companies that operate in the same industry (or in an adjacent sector).
The normalization of EBITDA alludes to the continued removal of items that are not representative of the company’s core operations and business model, as well as adjusting for non-cash items and accrual accounting conventions.
Thus, a company’s normalized EBITDA should exceed its traditional EBITDA metric in most scenarios, since additional measures were taken to “normalize” its earnings.
If the adjustments seem unreasonable and there is limited transparency in the sale process, the seller (and their sell-side M&A advisor) can lose credibility and trust from the buyer, which serves to widen the gap between the offer price and the sale price.
What are Examples of Non-Cash Add-Back?
The practice of companies disclosing non-GAAP earnings to offer more insight into their recent operational performance and financial position has become rather common in recent times to provide enhanced transparency into a company’s operating performance, with such non-GAAP measures presented as supplementary material.
The process of calculating EBITDA, however, can become more intricate due to the treatment of items such as stock-based compensation (SBC), with the resulting figure termed “Adjusted EBITDA”.
The add-backs to determine a company’s adjusted EBITDA are discretionary, and some examples of such non-recurring adjustments include the following:
- Litigation Settlements and Legal Fees
- Stock-Based Compensation
- Restructuring Fees
- Asset Impairments, i.e. Write-Downs / Write-Offs
- Gains / (Losses) on Sale of Assets
- Severance Packages
As a real-world example of a GAAP to non-GAAP reconciliation, see the adjustments made by Twitter, Inc. (TWTR) in its most recent reporting period (Q-2, 2022) prior to its take-private transaction.
Twitter Announces Second Quarter 2022 Results (Source: TWTR Q2-2022 Press Release)
Normalized EBITDA Calculator — Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Normalized EBITDA Calculation Example
Suppose you’re tasked with calculating the normalized EBITDA of a company in fiscal year ending 2022. The income statement assumptions we’ll use in our exercise are as follows.
|Less: COGS||(50 million)|
|Gross Profit||$50 million|
|Less: SG&A||(20 million)|
|Less: Interest||(2 million)|
|Taxes @ 30.0%||(8 million)|
|Net Income||$20 million|
From there, we’ll reconcile net income until we reach our company’s normalized EBITDA.
Therefore, our starting point is net income, to which we’ll add taxes and interest expense.
- Taxes: Taxes can vary substantially based on the jurisdiction, state of incorporation, historical profitability (i.e. NOLs), and more.
- Interest Expense: On the other hand, interest expense is a function of the total debt outstanding, which is a discretionary decision by management.
Following those two adjustments, we’ve worked our way back up to the operating income (EBIT) line item.
- EBIT = $20 million + $8 million + $2 million = $30 million
The next adjustment is to add back D&A since the two items are non-cash charges, wherein the actual outflow of cash occurred in the initial period. Here, we’ll assume that the D&A expense in the given period amounts to $5 million.
- D&A = $5 million
The final part of our exercise consists of three more adjustments, which are excess owner salary (i.e. new owner will receive less pay), litigation fees, and restructuring fees. The latter two types of fees are added back because neither fee is considered typical in the normal course of business and does not contribute to the company’s revenue model.
- Excess Owner Salary = $1 million
- Litigation Fees = $2 million
- Restructuring Fees = $2 million
In closing, the normalized EBITDA of our hypothetical company comes out to $40 million.
- Normalized EBITDA = $20 million + $8 million + $2 million + $5 million + $1 million + $2 million + $2 million = $40 million