Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a popular measure used by many investors and analysts today in valuing the profitability and cash flow of the businesses. I personally have never used EBITDA and don’t plan to for its inferior nature. Let me explain why I believe EBITDA to be fairly useless measure of cash flow when trying to value a business.
EBITDA History
EBITDA became popular in the 1980’s with the boom of Leveraged Buyout (LBO) activity. At that time, EBITDA was more relevant because the criteria of the deals typically excluded companies that required substantial cash investment for capital expenditures, R&D or inventory.
The use of EBITDA became popular in industries with expensive assets that had to be written down over long periods of time and has remained popular as a tool in determining purchase price multiples and analysts use it regularly in acquisition pricing and analysis.
EBITDA Definition
EBITDA = Revenue – Expenses (excl. tax, interest, depreciation & amortization)
As you can see, the definition of EBITDA factors out interest, taxes, depreciation and amortization. This can make even completely unprofitable businesses appear profitable and is also easily susceptible to fraudulent accounting. Many companies include EBITDA and refer to it as though it represents cash earnings since depreciation and amortization are non cash expenses. This is a common misconception. EBITDA does not represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow.
Not to mention that EBITDA also leaves out the cash required to fund capital expenditure, which is critical for any business.
The Lemonade Stand
A 10 year old kid wants to open up shop with the coming summer season and because he has no money, he is being funded by this parents. $50 comes his way for a cheap table, cups, pitcher, lemons and tip jar. At the end of the day, the parents want to know how much money was made. How does the 10 year old businessman reply? Does he quote an amount that is adjusted for tax, interest, and D&A?
EBITDA does seem quite ridiculous when we simplify (maybe oversimplified) it to an easy to understand example.
Free Cash Flow Instead of EBITDA
Rather than using EBITDA to try and measure profitability or cash flow, the better way would be to use cash flow from operations from the Statement of Cash Flows or free cash flow which is what I use when analyzing and valuating businesses.
Summary
- EBITDA gives the appearance of more cash than there actually is by leaving out so many expenses
- Neglects cash required for working capital
- Neglects debt payments and other fixed expenses
- Neglects capital expenditure
- EBITDA is NOT cash flow
- Since EBITDA is a gross earnings base, it is a large profit metric and makes multiples seem smaller which in turn is a poor choice for making price multiple comparisons.
- Investors should focus on other performance measures to make sure the company is not trying to hide something with EBITDA
April 6th, 2009 at 1:16 pm
As you say, using EBITDA hides capital expenditures. Particularly in businesses that require ample investment of capital, EBITDA masks the most important aspect from the potential investor.
The original Berkshire Hathaway (the textile mills, that is) had just this problem–lots of money spent on looms that were virtually worthless after they were depreciated. And you had to keep buying more just to keep the doors open.
Wide Moat’s last blog post..Moody’s Shrinking Moat
April 6th, 2009 at 6:11 pm
yeah, really cant beat free cash flow. this stock at net cash took off today aerg i put it on a watch list but missed it. well i should say it was at net cash : )
Mark’s last blog post..IIT, Pier Earnings, AERG Rockets
April 6th, 2009 at 10:28 pm
I’d argue, that problem with Berkshire’s textile mills was not that it was capital extensive, but rather that product was undifferentiated on the market place. This in turn caused non-existent pricing power and ultimately very low return on the invested capital. Any plant improvement quickly matched by the competition and margins got erased.
April 7th, 2009 at 10:01 am
Not saying that FCF is bad (I actually look at that a lot) but just to play Devil’s Advocate…
So what’s the downside to using FCF? Why doesn’t everyone on the Street use FCF? If it was so much superior how come the market relies on earnings instead? For instance, P/E ratio is far more popular than P/FCF ratio.
I’m just curious because many value investors seem to emphasize FCF but very few professionals analysts seem to concentrate on it. Is there something irrational about the market or is there some major pitfalls with FCF…Just wondering why…
Sivaram Velauthapillai’s last blog post..Not a pretty sight: Third Avenue sues MBIA
April 7th, 2009 at 10:40 am
I see the downside with FCF being that it is unreliable over a single period. FCF is a raw number showing how much cash is left after expenditures with no smoothing out and FCF tends to fluctuate widely for non predictable cash cow companies.
So the main disadvantage is that it is unable to accurately provide a picture for growth, start up and cyclical companies.
My opinion is that Wall Street uses P/E and EBIT or EBITDA because of its simplistic nature. Most professionals probably dont do near as much research and study than the average investor as they are pressed for time and deadlines. FCF isn’t included in the financial statements which takes time to calculate.
When I first started this blog I had an argument with a person that explains why the public do not use the proper metrics.
April 7th, 2009 at 6:58 pm
“unreliable over a single period. FCF is a raw number showing how much cash is left after expenditures with no smoothing out and FCF tends to fluctuate widely for non predictable cash cow companies.”
I was going to post about the same thing. …Tons of companies don’t even have FCF let alone cash from operations. Also the more variables you look at the less likely you are to get an accurate prediction. Unless you Buffett or valuing a monopoly like company
Mark’s last blog post..IIT, Pier Earnings, AERG Rockets
April 8th, 2009 at 5:17 am
Yeah, I agree with your thoughts. I rarely if ever look at EBITDA but I will always look at FCF. It’s much harder for a company to manipulate FCF to try to appear healthy when they aren’t. I tend to look for dividend stocks with low debt so I also always look at the quick or current ratios along with the payout ratio. High debt or dividends that aren’t supported by earnings are big red flags for me.
Greg’s last blog post..Quicksilver Gas Services – KGS
April 17th, 2009 at 2:09 pm
I will argue that the main drawback of FCF is the difficulty of estimating “maintenance CAPEX”. Most people use FCF with total CAPEX leading to miss growth stories or invest in business with shrinking moats.
For example, retailers in their early stages (TRLG, H&M) usually have very negative total CAPEX FCF because they are opening stores. On the other extreme, mature retailers (Wal-Mart, Walgreen, Starbucks) could hide operational or competitive problems. They could just stop investing and that automatically increases FCF. That is a reason why store metrics like same store sales and new openings are important.
That could lead to a whole discussion Lampert’s strategy for Sears Holdings SHLD, but space is limited.
April 18th, 2009 at 12:35 am
Figuring out the amount of maintenance capex is the difficult part and very time consuming so I usually skip it. I find it easier to be conservative and get the no brainer value stocks rather than try to calculate the growth aspect. I dont mind missing out on the Google’s Walmart’s and Microsoft’s.