What is EBITDA? Definition, formula and example

This is for buyers, sellers and investors who keep seeing "EBITDA" in listings and deal memos and want to be sure what it measures. By the end you will know the formula, how it differs from SDE, and how a multiple of EBITDA turns into a price.

What EBITDA means in plain words

EBITDA is the profit a business makes from running itself, before anyone decides how to finance it or how to account for its equipment. Interest depends on the owner's debt. Taxes depend on the owner's structure. Depreciation and amortization are paper charges for things bought years ago. Strip those out and you can compare two businesses on how well they operate.

It is not cash flow. A business still has to buy trucks, carry inventory and pay tax. EBITDA is a starting point for value, not the money you take home. Investopedia's EBITDA page makes the same point.

The EBITDA formula

EBITDA = net income + interest + taxes + depreciation + amortization

Each line comes straight from the profit-and-loss statement or the tax return. Nothing else is added back. If a broker adds back the owner's salary, a one-time cost or a family member on payroll, the figure is no longer EBITDA. It is adjusted EBITDA, and every adjustment needs proof.

EBITDA versus SDE

The key difference is the manager's salary. Seller's discretionary earnings (SDE) adds back one owner's whole salary and perks, because the buyer will do that job. EBITDA leaves a market salary for one manager in the costs, because the buyer will pay someone to run the business.

So for the same company, SDE is higher than EBITDA by roughly one manager's pay. Smaller owner-run businesses are priced on SDE. Businesses with a management team, and most deals over a few million dollars, are priced on EBITDA. Mixing the two multiples is the fastest way to overpay.

A worked example

Illustrative example: a $4M-revenue commercial cleaning company with a general manager in place.

At 4 times EBITDA the business is worth about $2,000,000. If the owner also worked full time without a salary, a buyer would subtract a market wage first, because EBITDA should already carry a manager's pay.

Where EBITDA shows up in a deal

In a listing or a CIM, the asking price is usually a multiple of EBITDA or SDE. Ask which one. In the bank's file, a lender turns EBITDA into cash available for debt and tests the loan against it; the SBA's 7(a) program is the usual route for deals under about $5 million. In a private equity memo, EBITDA is the number the whole return model hangs on.

EBITDA is not a GAAP measure. Public companies that report it must reconcile it to net income under the SEC's rules on non-GAAP measures. Private sellers face no such rule, which is why a buyer rebuilds the figure from tax returns before trusting it. That rebuild is a normal step in buying a business.

Common mistakes

• Treating EBITDA as cash. Capital spending, working capital and tax still come out of it.
• No manager's salary in the costs. If the owner runs the business for free, EBITDA is overstated.
• Pricing on one year. Three years show the trend; one good year shows a good year.
• Confusing EBITDA with adjusted EBITDA. The add-backs can be fair, but they must be listed and proven.