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EBITDA is classified by some commentators as a cash flow measure of value. EBITDA (pronounced e-bit-dah} means earnings before (deduction of) interest, taxation, depreciation and amortisation. Many financiers and press reporters use EBITDA in a ratio with enterprise value, EV (market value of equity + market value of debt – cash in the business). It is compared to EV, rather than equity value, because it includes the interest element.
The common use is to compare the EV/EBITDA multiple of the company the commentator is examining with the multiples currently shown for comparable companies.
For instance, when one company attempts to take over another the press often look at the EV/EBITDA multiple the acquirer is offering in the light of the multiples paid for other recently acquired companies in that sector, and in the light of the current multiples for comparable stock market quoted firms, e.g. those at roughly the same risk level.
There are a number of benefits claimed for the use of EBITDA in valuation:
- EBITDA is close to cash flow.
We cannot say this. It does not take account of tax payments or the need to invest in working capital, for example. It is still vulnerable to a wide range of accrual accounting adjustments, e.g. the valuation of receivables.
- Because the estimation of depreciation, amortisation and other non-cash items is vulnerable to judgement error we can be presented with a distorted profit number in conventional valuations; by focusing on profit before these elements are deducted we can get at a truer estimation of cash flow.
When making comparisons between firms and discovering a wide variety of depreciation methods being employed (leading to poor comparability) this argument does have some validity: to remove all depreciation, amortisation etc. may allow us to compare the relative performances more clearly.
However, this line of reasoning can take us too far away from accrual accounting. If we accept the need for accrual accounting to provide us with more useful earnings numbers, then we simply cannot dispose of major accrual items when it suits us.
By using EBITDA we distort the comparison anyway, because high capital expenditure firms are favoured by the removal of their non-cash item deductions.
- If we are focused on future income from the firm’s operations we need not allow for the depreciation and amortisation because this is based on historical investment in fixed assets that has little relationship with the expected future capital expenditure.
While alighting on a truth, the substitution of EBITDA for conventional profit (or for proper cash flow numbers) is wrong because it fails to take into account the need for investment in fixed capital items (and working capital).
In the real world directors (and valuers) cannot ignore (however much they would want to) the cost of using up and wearing out equipment and other assets or the fact that interest and tax need to be paid.
Warren Buffett made the comment: ‘References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?’
- EBITDA is more useful for valuing companies that do not currently make profits, thus enlarging the number of companies that can be analysed.
But note that the more soundly based methods can be used for companies that are currently loss-making – we simply forecast future cash flows, dividends or earnings. EBITDA does not really have an edge in this regard.
- When comparing firms with different levels of borrowing EBITDA is best because it does not deduct interest.
It is true that EBITDA increases comparability of companies with markedly different financial gearing, but it is also true that the less distortionary EBIT (earnings before interest and tax deduction) can do the same without the exclusion of depreciation or amortisation.
Standing against the tide
I will not be promoting of EBITDA as a useful measure of valuation, because it can lead to some very distorted thinking.
EBITDA became a very popular measure……………..
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