Valuing a company with negative EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) can be quite challenging, but it’s not impossible.
Negative EBITDA usually indicates that the company isn’t profitable from an operational perspective.
However, it may still hold significant value based on its market potential, assets, and growth opportunities.
In this guide, we’ll discuss how you can evaluate such a company’s worth using alternative valuation indicators to help uncover its true potential.
What Happens if EBITDA is Negative?
Before we dive into more intricate details, let’s first try to understand what happens if a business has negative EBITDA and what you do if EBITDA is negative.
When a company has negative EBITDA, it means the business is not profitable from its core operations.
This negative figure can raise red flags for potential investors, as it shows that the company’s operational expenses exceed its income before any financing, tax, or capital expenditure adjustments.
Here’s how negative EBITDA affects different aspects of valuation and investment:
Increased risk: Negative EBITDA often reflects high operational costs or low revenue, which could lead to investor caution.
Cash flow strain: A business with negative EBITDA may be facing cash flow issues, to the point that it may potentially require external funding.
Financing challenges: Securing debt is harder and may come with higher interest rates, as lenders view negative EBITDA as a credit risk.
Restructuring needs: The company may need to cut costs or boost revenue to reverse its negative EBITDA and improve financial stability.
Best Approaches for Valuing A Company With Negative EBITDA:
Valuing a company with negative EBITDA can be challenging, but with the right approach, it's possible to assess its true potential and future prospects.
In this section, we’ll take a closer look at the essential strategies and methods you can employ:
Revenue-Based Valuation
When evaluating a company with negative EBITDA, one of the alternative indicators you can rely on is revenue.
This can serve as a reliable signal of its growth potential—especially in industries where profit often follows substantial revenue growth.
There are two ways to use the revenue factor in this case as explained below…
1. Revenue multiples
Revenue multiples is a suitable option for estimating the value of a troubled business with negative EBITDA. This approach simply compares the company’s revenue to others in the industry.
It is particularly useful when dealing with startups and growth-oriented businesses.
You can use industry-specific revenue multiples to help you assess the business’s relative worth.
For instance, tech companies might be valued at a higher multiple (e.g., 5–10x revenue) than retail companies (e.g., 1–3x revenue).
Alternatively, you can focus on the business’s historical revenue growth. Companies with a strong revenue growth history may command higher multiples, as growth can be an indicator of future profitability.
2. Revenue Run-Rate
When dealing with a newer company, using the revenue run rate can help you project its future performance by annualizing recent revenue figures.
This method is useful for seasonal businesses or rapidly growing companies.
To calculate run-rate, you simply multiply the latest month’s or quarter’s revenue by 12 or 4, respectively, to get an estimated annual revenue figure.
For a high-growth business, you may consider adjusting the run rate to account for anticipated growth, especially if revenues are increasing rapidly.
Asset-Based Valuation
Another way to go around a company with negative EBITDA is by focusing on its tangible and intangible assets.
Tangible assets are simply physical assets, such as real estate, equipment, and inventory. In some cases, these assets alone can justify the acquisition price.
Intangible assets, on the other hand, include intellectual property (IP), brand reputation, and customer relationships.
Such assets can make a company valuable even when its financials aren’t strong.
Discounted Cash Flow (DCF) Valuation
The traditional Discounted Cash Flow (DCF) model may not be directly applicable when EBITDA is negative.
However, using adjusted DCF model will offer you valuable insights by refining key assumptions to account for the company’s current financial situation and future potential.
So, how does adjusted DCF work?
It simply involves adjusting the projections for future cash flows to reflect the expected improvements in operations, cost reductions, or potential revenue growth.
When estimating future cash flows, you want to adjust for non-recurring costs or inefficiencies that, if eliminated, could significantly enhance future cash flow.
Additionally, you should base the future revenue projections on conservative assumptions. This is to ensure that growth expectations are realistic and not overly optimistic given the company’s challenges.
Another crucial adjustment is to apply a higher discount rate to reflect the additional risk associated with negative EBITDA. This helps account for the heightened risks in the business.
Adjust the risk premium to mirror the likelihood of financial instability, ensuring the valuation accurately reflects the investment’s risk.
And when estimating the exit value, you should still apply conservative assumptions to account for potential challenges.
These adjustments will help you create a more realistic valuation, even in the face of negative EBITDA.
Comparables Method
Analyzing comparable transactions in the industry provides you with a benchmark valuation based on real-world acquisitions of similar companies.
This approach requires you to first search for recently sold companies with negative EBITDA in the same industry.
Industry reports or transaction databases can offer insight into acquisition multiples for similar cases.
Keep the following in mind when looking for comparable companies:
Review the revenue multiples or other valuation metrics used in these transactions to gauge a range for your target company.
Ensure the comparables are similar in size, market position, and business model for more accurate benchmarking.
Can You Do a DCF with Negative EBITDA?
Yes, a DCF can be performed with negative EBITDA. However, as we mentioned earlier, it requires several adjustments to ensure a more accurate evaluation as outlined below:
Adjusted cash flow assumptions: Forecasts should reflect realistic operational improvements or revenue growth.
Higher discount rate: This adjustment allows you to account for added risk, and results in a more conservative valuation.
Path to profitability: Model a scenario where EBITDA eventually turns positive, allowing for improved future cash flow estimates.
Alternative Exit Values: Instead of EBITDA multiples, consider revenue-based or industry-specific benchmarks to calculate a terminal value, especially for high-growth companies.
These approaches help you easily adapt valuation techniques to companies with negative EBITDA, offering you a clearer view of their potential worth.
Final Thoughts
Valuing a company with negative EBITDA may seem impossible but it’s doable if you look beyond traditional profitability metrics. Just focus on alternative indicators including revenue trends, assets, and market comparables. These will help you uncover the hidden value and provide a solid foundation for your valuation. With careful analysis, you can identify opportunities to maximize value despite financial challenges.
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