What Is EBITDA And Why Is It Important? Via CSInvesting
This is an examination—taking the best of other literature and experts–of one metric: EBITDA but it also is designed to teach placing investment/analytical tools into perspective. Though repetitive, a careful reading will allow you to gain skill in examining the strengths and weakness of any accounting and measurement tool.
What is EBITDA and Why IS IT IMPORTANT
John H. Tracy and Tage C. Tracy
One of the most commonly referenced terms relies on financial reference points used by financial and accounting types is the ever popular EBITDA or earnings before interest, taxes, depreciation, and amortization. EBITDA has been around for decades but gained a significant amount of interest and use back in the 1980s during a period when leveraged buyout strategies were utilized to purchase companies.
What the buyers and their financing sources really needed to understand was how much EBITDA (or in their mind organic or internal cash flow) a company could generate to support future debt service payments. For example, if a company generated $10 million a year in EBITDA and the debt service requirements associated with the leveraged buyout was $6 million per year, then more comfort was gained that the company could adequately make the annual payment of $6 million (with some room to spare), But let’s look a little closer at this all important metric and its relation to “cash flow.” You frequently see cash flow mentioned in the business and financial press. In reading news items and articles, often it’s not clear what the reporter means by the term cash flow. Reports usually don’t offer definitions of the term as they are using it.
EBITDA means earnings before (deduction of) interest, taxation, depreciation and amortization. Many financiers and press reporters use EBITDA in a ratio with enterprise value, EV (Market value of equity + market value of debt minus surplus cash (cash not needed in the annual operations of the business)). It is compared to Enterprise Value (“EV”), rather than equity value, because it includes the interest element.
EV/EBITDA = (Mkt. Val. of Equity + Mkt. Val. of Debt – Cash)/EBITDA
The common use is to compare the EV/EBITDA multiple of the company that the analyst is examining with the multiples currently shown for comparable companies. For instance, when Kraft tried to take over Cadbury in 2009 the press looked at the EV/EBITDA multiple Kraft was offering in the light of the multiples paid for other recently acquired food companies and in the light of the current multiple for stock market quoted comparable firms.
See Press Release on Kraft Bid for Cadbury: LONDON, Sept 23 (Reuters) – Cadbury CBRY.L Chief Executive Todd Stitzer noted that past deals in the industry have been agreed at higher multiples than that implied by the offer from Kraft (KFT.N), according to a Bank of America/Merrill Lynch note obtained by Reuters. The note was published by sales specialist Simon Archer and based on Stitzer’s remarks at a closed investor conference in London. As originally published, the note said: “On price, Todd seemed to admit that a 15x EBITDA multiple would be a fair price.” But Archer has since issued a clarification saying Stitzer’s comments “were only in the context of comparable transactions being in the mid-teens – he was not implying a fair value for the business”. Stitzer’s exact remarks were not immediately available either from Archer or Cadbury.
There are a number of benefits claimed for the use of EBITDA.
- EBITDA is close to cash flow. Not really. It does not account for tax payments or the need to invest in working capital (all growth requires investment!), for example. It is vulnerable to a wide range of accrual account adjustments, e.g. the valuation of debtors.
- Because the estimation of depreciation, amortization and other non-cash items is vulnerable to judgment error, we can be presented with a distorted profit number; by focusing on profits before these elements are deducted, we can get at a truer estimation of cash flow claim EBITDA’s advocates. 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, amortization 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 favored by the removal of their non-cash item deductions.
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