EBITDA or FCF – When Can You Use One or the Other?
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 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 = 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
Let’s me tell you a story. But before that, click on the image below to download the best investment spreadsheet to help organize your thoughts and make things easier for you.
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.
- 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
What is Old School Value?
Old School Value is a suite of value investing tools designed to fatten your portfolio by identifying what stocks to buy and sell.
It is a stock grader, value screener, and valuation tools for the busy investor designed to help you pick stocks 4x faster.
Check out the live preview of AMZN, MSFT, BAC, AAPL and FB.