Thursday, March 10, 2016

Using EBITDA the Right Way

There are some things bankers and M&A advisors seem to really love talking about: what they found in due diligence, growth opportunities, working capital, multiples, and EBITDA.

M&A advisors talk a lot about EBITDA (Earnings Before Interest, Tax, Depreciation/Amortization) because transaction values are typically referred to as a "multiple of EBITDA." If your company has $3M in EBITDA and sells for $10.5M, then we say "this company got a 3.5x multiple."

However, a lot of people disparage EBITDA as a metric and some people are confused how much they should care about it. 

It is very important to remember that EBITDA is not the alpha and omega of value. It's just one tool in the valuation toolbox. People use a lot of different metrics to value companies. You cannot represent the earning power of every business model based on EBITDA.

If you are thinking about selling your company, EBITDA is something you're going to think about a lot -- but you need to know what it is and what it isn't. No buyer will evaluate a company purely in terms of EBITDA -- if they do, they're at a big disadvantage.

EBITDA sometimes gets undue emphasis, but it also gets undue criticism. Let's look more carefully at what it means.

Most of the time the anti-EBITDA folks are attacking a strawman. They say things like "EBITDA are fake earnings" and "I’ve never seen a business owner who takes home anything close to EBITDA."

These would be valid complaints if EBITDA were used to describe “real earnings” or if it were claimed to be the amount the owner gets to put in his pocket. In reality, no who wants to be taken seriously is taking those positions.

People love to cite Warren Buffett on matters pertaining to finance and investing. He is a well-known critic of people talking about EBITDA this and EBITDA that. In the 2002 Berkshire Hathaway annual report, he wrote:

"Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense." 

Buffett correctly points out that this is nonsense, but again, I don't know what people are saying "depreciation is not truly an expense." Most finance and accounting types do in fact understand that it's a real expense. It doesn't correspond to the actual outflow of cash; it spreads out the expense for a capital asset over time which is clearly a genuine expense.

If someone actually identifies EBITDA as cash flow and assumes a company doesn't ever have to make capital expenditures, you should seriously reconsider the value of what they are saying. Fortunately most people don't actually think that way. Any business owner will tell you they recognize that plant and equipment assets wear out and need replacement.


So why do advisors talk about EBITDA so much anyway? Why not focus on Net Income (or something else, for that matter)?

To put it in perspective, think about who gets paid when a company earns money: shareholders, lenders, and the taxman.

Take the Net Income right off an income statement and that's basically after-tax earnings left over for shareholders after interest has been paid and the government has taken its slice.

Before we talk about EBITDA, let's consider EBIT (Earnings Before Interest & Taxes). This is just the Net Income with the interest and tax expenses added back in.

That means EBIT ignores the effect of capital structure (i.e. how the company is funded, which drives the "I" in EBIT) and taxes (the "T") to focus on the "core" operations of the business. Importantly, it includes the impact of spending money on capital assets (because the depreciation expense is included).

Unlike Net Income, EBIT reflects money that could go to shareholders and lenders and the government. It's useful because it gives an idea of earnings that could go to owners and how much debt it might sustain. Additionally the tax rate is mostly a given but also affected by events in previous tax years.

EBITDA takes EBIT and adds back depreciation & amortization expenses which reflect spending on property, plant, and equipment. That means EBITDA tries to be an approximation of Cash Flow from Operations on the cash flow statement, where Depreciation and Amortization is also added back because it's a non-cash expense.

Practically, the real Cash Flow from Operations number can be annoying to calculate whereas EBITDA is very simple, hence its popularity.

But remember, it's only an approximation. The actual Cash Flow from Operations includes interest, taxes, and changes in working capital. But relative to Net Income and EBIT, EBITDA will usually (not always) be closer to Cash Flow from Operations. And while it is like EBIT in the sense that it is money that would be distributed to everyone -- the equity investors, the creditors, and the state -- the actual number would be lower because with EBTIDA, companies at the very least still need some capital expenditures to replace old equipment.

So EBITDA is only a quick proxy for Cash Flow from Operations -- which is not the same as profitability. Like EBIT, it looks at the "hard" core of business in terms of its operations, but EBIT is more of a proxy for Free Cash Flow.

Here are a few important things that are not included in EBITDA:
  • Capital expenditures (capex): A lot of companies need to spend cash on property, plant, and equipment assets in order to sustain and grow their businesses. EBITDA doesn't include any of that spending, because it excludes the depreciation/amortization expenses. That means it will always overestimate cash flow to some degree. On the other hand, EBIT could underestimate cash flow -- because even if the Depreciation and Amortization is included, there is no distinguishing between capex for growth vs. capex needed merely to sustain current business levels. It can be more complicated still because companies might have capex to diversify or match their competitors in some area. Capital expenditures are in many ways a function of overall management goals. A company trying to grow aggressively will tend to require greater capex than a company with more conservative growth targets.
  • Working capital requirements: If your working capital needs are decreasing, then that improves valuation, because it frees up more cash. If working capital needs are increasing, this puts downward pressure on the valuation because it ties up more cash. This can be influenced by management decisions like maintaining redundant levels of inventory or credit arrangements with customers and vendors. Fast growing companies have high working capital requirements to accommodate the receivables and inventories. EBITDA doesn't deal with working capital at all, unlike actual cash flow from operations.
With these important exclusions, why do people use EBITDA at all?

EBITDA is useful because sometimes you just want to get a basic look at a company's core business. You don't care how they fund the company (capital structure), tax rates, and individual management decisions that influence working capital levels and capital expenditures.

When a company is sold, it's usually on a debt-free basis where the vendor settles all or most liabilities at closing. This means the capital structure will differ in the hands the new buyer. The tax situation may be different when the ownership changes as well. So there is some justification in utilizing a metric that looks at a company without those factors.

When it comes to depreciation, remember that at best it's an estimate about the life of an asset. A machine might be depreciated to zero yet remain very functional with a substantial amount of fair market value left in it. You don't want to ignore depreciation because it's "non-cash", but you might want to consider it separately from the "core" earnings number.

So despite the complaints about EBITDA, there is logic behind using it as part of one's analysis.
EBITDA is one of the initial filters when a buyer is considering an acquisition. A lot of strategic buyers and private equity firms often won't even look at a company unless it's at least in the 10-20% EBITDA range, and then they start checking under the hood. Getting past those early filters is just part of the analysis though. A company might have very high EBITDA but also underlying issues that still make it a financially weak company.

You would never take an Oil & Gas production company (high capital expenditure requirements), an advertising firm (very low capex requirements), an internet app developer (probably a lot more R&D than investing in big equipment), and compare them all in terms of EBITDA.

In different industries, EBITDA margins are going to mean very different things. A company with lower EBITDA might still produce more Free Cash Flow than a company with higher EBITDA! However, if you are comparing two companies in the same industry, and want a simple approximation to gauge their cash flow from operations, EBITDA can be useful.


After reading this, you probably want an answer to this question: "Should I use EBITDA to measure the value of my company?" 

The question potentially is linked to a false premise, so the answer is "yes" with the proviso that you should never rely on a single metric to value something. Understanding EBITDA's uses and limits helps avoid ideas of value that are confusing and/or confused.

EBITDA in most cases is just the start of an analysis. It allows a quick smell test enabling a snap shot of “GO or NO GO” before further investigation. Buying or running a company with a high EBITDA in and of itself should not be anyone's endgame.