Recent historical earnings are typically averaged as part of normalizing EBITDA when estimating business valuation in client financial plans.
RISR estimates average historical EBITDA by taking a weighted average of the most recent three years of earnings, weighting recent years more than former years.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is is a measure of a company’s operating profitability. In financial planning with business owners, it's a key component of estimating normalized EBITDA, which is used in business valuation.
Taking a weighted average of recent historic EBITDA helps reflect the business's current ability to generate earnings, signals the trajectory of the business, and helps smooth out any impacts from one-off events that may have impacted earnings.
Estimating EBITDA
EBITDA = Net Income + Interest expense + Depreciation + Amortization
Estimating Average Historic EBITDA
Avg. Historic EBITDA = [(EBITDA Year 1 x 3) + (EBITDA Year 2 x 2) + (EBITDA Year 3 x 1)] / 6
(Where Year 1 = the most recent year)
It is recommended that the most recent three years of historical financial performance are referenced when estimating business valuation.
Why isn't a simple average of EBITDA used when estimating business valuation?
Simple averages may be appropriate to use when earnings have been relatively consistent, but aren't as effective at showing these trends as a weighted average is.
Weighted averages place more emphasis on recent years to better reflect the business’s current earning power and future potential based on recent trends.
