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Understanding EBITDA and Valuation Multiples:
If cash is king, why does everyone talk about EBITDA?
The value of a business is primarily driven by two factors, its cash flow and the appropriate multiple. The cash flow measures what the business owner can expect to realize from his or her investment on an annual basis. The multiple converts the annual cash flow to value reflecting its risk and potential for future growth. When dealing with cash flow, the multiple will reflect the business’ weighted average cost of capital or WACC (i.e. the business’ required rate of return determined as the weighted average of the after-tax costs of debt and equity). As you can imagine, the determination of cash flow, rates of return and growth potential can be complicated. Accordingly, the business world often gravitates toward EBITDA as a proxy for cash flow to measure performance and determine value.
Cash Flow and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
EBITDA is a useful tool because it’s easy to understand and facilitates comparison among companies operating in different jurisdictions and/or different capital structures. However, it’s an incomplete measure of financial performance in that it ignores crucial factors such as debt-service costs (the interest and capital paid to the bank each month), capital expenditures (investments in buildings, machinery, trucks and computers essential to a company’s operations) and income taxes.
Seasoned investors and their advisors understand the differences between EBITDA and cash flow and generally would not be comfortable determining value simply as a multiple of EBITDA. Let’s consider why:
Capital expenditures can be significant. Suppose two companies each generate $5M of EBITDA and are offered for sale at $20M. One company, a service business, requires nominal capital expenditures. The other, a retail chain, requires $2M annually, mainly for store renovations. All else being equal, which one would you rather buy?
The service business has higher cash flow, resulting in a higher return on your investment. Warren Buffett considers this point in Berkshire Hathaway’s 2000 annual report:
“References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.”1
Debt (Leverage) Matters. Suppose RetailCo has $4M of annual debt service costs, $1M more than its pre-tax cash flow. Despite its positive EBITDA, the company is cash flow negative and may be insolvent within a year!
Taxes are a real expense. Benjamin Franklin wrote: “… in this world nothing can be said to be certain, except death and taxes.”2 Dr. Franklin was right, taxes cannot be ignored. While an EBITDA multiple implicitly reflects income taxes, it may not capture the specific tax attributes of the target company. A cash flow approach to valuation will typically consider the most likely tax jurisdiction and form of ownership, both of which can have a significant impact on the purchaser’s expected return.
EBITDA is easily manipulated. There are no agreed upon standards for EBITDA calculations nor does EBITDA comply with Generally Accepted Accounting Policies. Lynn Turner, former chief accountant at the Securities & Exchange Commission, once said that analysts’ preoccupation with EBITDA helped mask accounting frauds like those at WorldCom, Enron and Sunbeam: ‘‘EBITDA lulled the investing public into a trance with imaginary numbers, just as if they had gone to the movies,’’ he said. ‘‘Little did they know that the theater was burning the entire time.’’3
I’m going to let you in on a little secret. While investors and their advisors often refer to EBITDA multiples, more often than not, behind the scenes, they’re running a complicated cash flow model to determine the value of the target company. The model runs on after-tax cash flow and reflects the company’s WACC. The investor will have mapped out the optimal debt level and the right equity return. The determination of value is actually a lot more precise than simply applying a multiple to the target company’s EBITDA.
Once value has been determined, the implied EBITDA multiple can be calculated. It is simple to do and easy to understand. As a result, it’s often used as a reference point in a Letter of Intent when pricing a transaction. The deductions from EBITDA to arrive at after-tax cash flow are captured in the implied multiple. The deal therefore becomes easier to understand and financial due diligence can focus on EBITDA4 , which despite the points discussed above, still drives the company’s cash flows.
The Bottom Line
In business, cash is king. This is as true in buying a business as it is in running one. While EBITDA is a useful measure of performance and EBITDA multiples are easy to understand, they are far from perfect. Unless a ‘quick and dirty’ valuation is appropriate for your needs, consider a more comprehensive (and meaningful) valuation based on after-tax cash flow. You’ll gain a greater understanding of the business and will be able to make better investment decisions.