EBITDA multiple vs capitalization rate

Buyers who see both a multiple and a cap rate in valuation material can reasonably ask whether they are two names for one thing. They are not. Each starts from a single period of earnings and ends at a value, but they are built differently and sit in different families of valuation method. This page covers business earnings only, not the capitalization rate used for real estate, which the sources below do not address. It sets out how each figure is defined, where its number comes from, and what a reader can ask when one is quoted.

What an EBITDA multiple is

The CBV Institute defines a multiple as a ratio of the value of a business or security to economic income or a non-financial metric, also called a market multiple, pricing multiple or valuation ratio. Its Guideline Transaction Method sits in the Market Approach and applies multiples derived from transactions of controlling interests in companies in the same or similar lines of business. BDC says market-based approaches calculate a valuation by applying a valuation multiple, which may be based on EBITDA, revenue or other metrics.

• It is a ratio of value to earnings, observed in market pricing.
• Its figure comes from comparable transactions or companies.
• BDC lists applying an inappropriate EBITDA multiplier among valuation mistakes.

What a capitalization rate is

In the CBV Institute’s definitions, the Capitalization of Economic Income Method sits in the Income Approach: expected economic income for a representative single period is converted to value through division by a capitalization rate. A capitalization rate is a divisor, usually expressed as a percentage, used to convert into value the expected economic income of a normalized single period. It is generally calculated as a discount rate less a long-term growth rate.

• It is a divisor applied to one normalized period of earnings.
• The CBV Institute says it is generally calculated as a discount rate less a long-term growth rate.
• BDC says capitalized cash flow is used when cash flow is expected to remain stable in future years.

Where the number comes from

A multiple is observed from comparable pricing, so its quality depends on how closely the comparables resemble the business. A capitalization rate is constructed, so its quality depends on the judgment behind it. CRA Information Circular IC89-3 says the risk, expressed in a going concern value calculation as the capitalization rate, relates to factors such as the stability or irregularity of the maintainable level of earnings or cash flows, the tangible asset backing, specific industry and market comparisons, and the financial condition of the specific business. The Circular adds that the valuator must exercise judgment in determining the extent to which these and other factors are relevant in quantifying a capitalization rate.

What both depend on

Both need an earnings figure that represents the business. BDC lists failing to normalize earnings by adjusting for special factors, such as discretionary and non-recurring items and non-market-rate revenues and expenses, among valuation mistakes. BDC also lists inappropriately mixing valuation methods. When a figure is quoted, ask which method produced it and whether the earnings were normalized first. The EBITDA multiple answer explains the multiple on its own terms and does not cover the capitalization method.

How to decide between them

These are conditions to weigh, not a recommendation, and a qualified professional can apply them to a specific business.

• If future earnings are expected to stay stable, BDC says capitalized cash flow is used; if they are expected to fluctuate substantially, BDC says discounted cash flow is used.
• If comparable sales exist to derive a multiple from, a multiple has market evidence behind it; if not, ask whether an income-approach method, such as a capitalization rate, is being used instead.
• If the risk factors in IC89-3, such as earnings stability, asset backing, and industry and market conditions, apply differently to the business, the rate changes with them.
• If earnings have not been normalized to a representative single period, neither figure is reliable.
• If the figure is for a lender, a tax filing or a dispute, ask whether a credentialed valuator is needed.