Question

Question 4.

Suppose that your firm has higher fixed cost-to-variable cost ratio than comparable firms. Explain how EBITDA multiple valuation would be influenced by the difference in this ratio.

Answer 1

Answer:

Various measures can be used to interpret operating leverage. These include the ratio of fixed costs to total costs, the ratio of fixed costs to variable costs, and the Degree of Operating Leverage (DOL). All of these measures depend on sales. The ratios of fixed cost to total costs and fixed costs to variable costs tell us that if the unit variable cost is constant, then as sales increase, operating leverage decreases. The DOL tells us, as a percentage, that for a given level of sales and profit, a company with higher fixed costs has a higher contribution margin – the marginal profit per unit sold. Therefore, its operating income increases more rapidly with sales than a company with lower fixed costs (and correspondingly lower contribution margin).

The EBITDA multiple is a financial ratio that compares a company’s Enterprise Value to its annual EBITDA (which can be either a historical figure or a forecast/estimate). This multiple is used to determine the value of a company and compare it to the value of other, similar businesses.

A company’s EBITDA multiple provides a normalized ratio for differences in capital structure, taxation, fixed assets, and for comparing disparities of operations in various companies. The ratio takes a company’s enterprise value (which represents market capitalization plus net debt) and compares it to the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) for a given period.

EBITDA or Earnings before Interest, Tax, Depreciation, and Amortization is the income derived from operations before non-cash expenses, income taxes, or interest expense. It reflects the company’s financial performance in terms of profitability prior to certain uncontrollable or non-operational expenses.

A higher EBITDA margin indicates a company’s operating expenses are smaller than its total revenue, which leads to a profitable operation. EBITDA can also be compared to sales as an EBITDA Margin.