Value Investing

EV / EBITDA Valuation Issues – Case Study

EV / EBITDA Valuation Issues – Case Study by CSInvesting

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This is a thorough 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.

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 – Excess 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.
  • Another argument: If we are focused on future income from the firm’s operations we need not allow for the depreciation and amortization because this is based on historical investment in fixed asset that has little relationship with the expected future capital expenditure. While alighting on a truth, the substitution of EBITDA for conventional profit (or for proper cash flow numbers) is wrong because it fails to take into account the need for investment in fixed capital items (and working capital). In the real world, directors (and valuers) cannot ignore however much they would want to the cost of using up and wearing out equipment and other assets or the fact that interest and tax need to be paid. Warren Buffett made the comment: "References to EBITDA make us shudder—does management think the tooth fairy pays for capital expenditures?
  • EBITDA is more useful for valuing companies that do not currently make profits, thus enlarging the number of companies that can be analyzed. But note, that all the methods described in this chapter can be used for companies that are currently loss-making—we simply forecast future cash flows, dividends or earnings. EBITDA does not really have an edge over the others in this regard.
  • A final argument: When comparing firms with different level of borrowing, EBITDA is best because it does not deduct interest. It is true EBITDA increases comparability of companies with markedly different financial gearing, but it is also true that the less distortionary EBIT (earnings before interest and tax deduction) can do the same without the exclusion of depreciation or amortization.

EBITDA can lead to distorted thinking and may not be a useful measure of valuation for most companies that require capex. Some companies heavily invested in real estate may have minimal maintenance capex like the records storage company--Iron Mountain (IRM)--so EBITDA may be used as non-growth pre-tax gross cash flow. EBITDA became a popular measure of a company’s performance in the late 1990s. It was especially popular with managers of firms that failed to make a profit. Managers emphasized this measure in their missives to shareholders because large positive numbers could be shown. Some cynics have renamed it, earnings before I tricked the dumb auditor.

If you manage an Internet company that makes a $ 100 million loss and the future looks pretty dim unless you can persuade investors and bankers to continue their support, perhaps you would want to add back all the interest ($50m), depreciating on assets that are wearing out or becoming obsolete (say $40), and the declining value of intangible assets, such as software licenses and goodwill amortization of $65m, so that you could show a healthy positive number on EBITDA or $55m.

The use of EBITDA by company directors can make political spin doctors look like amateurs by comparison. EBITDA is not covered by any accounting standards so companies are entitled to use a variety of methods—whatever shows the company in the best light.

Another ratio that is calculated is market capitalization (market value of all the ordinary shares) divided by EBITDA. The problem here is that the numerator is an equity measure whereas the denominator relates to income flowing to both debt and equity holders. Those companies with very high debt burdens will look reasonably priced on this measure, when in fact they might be overpriced.

Having listed the drawbacks of the use of EBITDA in valuation, judging the financial stability and liquidity of the firm. A key measure is the EBITDA to interest ratio. That is how many times greater are the earnings of the company than the gross annual interest bill: EBITDA interest coverage = EBITDA/Gross interest

This is used to judge short-term ability to pay interest if the firm could stop paying out for fixed capital items. But, there might still be taxes to pay above and beyond this. Also note that while capital item expenditure may be stopped in the short-run, if the company wants to maintain competitive position it will need to keep up with rivals.

Case Study: Federated/Campeau Debt is Destiny

Wall Street was saying that retailers were "cash cows." An LBO entrepreneur, they said, could rely on the celebrated EBIT-DA to pay interest charges. But, alas, this cow had already been milked. The pro forma EBIT-DA at the time of the LBO was about $700 million. One senior official at Federated said that the annual level of capital expenditures required just to maintain market position, without growth (maintenance capital expenditures or MCX), was about $200 million and that an additional $75 million to $90 million a year was required to fund the additional working capital for same-store growth in accounts receivable and inventories. Even EBIT-DA would not be enough to cover those outlays and also $600 million of interest charges. Federated would be in the best of times (without normalization or allowing for hard times) for retailing about $150 to $200 million short. Interest expense exceeded operating profit, so without a debt restructuring, the company was doomed. The Wall Street "story" was smoke and mirrors. The bankruptcy and full horror story are here:

Regular users of EBITDA are the private equity firms, particularly when trying to sell a company that they have been running. Long-term capital expenditure to maintain the firm’s competitive position, unit volume and invest in positive NPV projects may not be their highest priority when preparing a company for sale—so caveat emptor. Be wary if a company directs you to their EBITDA numbers especially if their products are subject to large depreciation charges.


Putting EBITDA in Perspective by Moody’s Investors Service

Ten Critical Failings of EBITDA as The Principal Determinant of Cash Flow from Moody’s "Putting EITDA in Perspective."


EBITDA is earnings before interest, taxes, depreciation and amortization—sometimes called "gross" cash flow.

A financial instrument of measurement, often used to value a company (expressed as a multiple of EBIT) This measure is calculated in the profit and loss statement of a company. Depending on the accounting methods, it can be calculated from the revenues minus such inputs as costs of goods and services sold and also wages; marketing, general and administrative expenses. EBITDA can be used as a rough tool for comparison for businesses like real estate or land companies where large, ongoing needs for capital expenditures are minimal. However, as this paper will show, EBITDA can be misused as an analytical tool.

EBITDA are bullsh*t earnings – Charles T. Munger.

Without deducting maintenance capital expenditures, "MCX" (the necessary expenditures to keep the business in its current state) from EBITDA the figures can be misleading--Editor.

This section has more than you need to know about understanding EBITDA, but place your use of EBITDA into context to understand the purpose of such a metric. After you finish reading this section, you will know more about the use and abuse of the EBITDA metric than most professional analysts.

Before continuing your reading, please try to think about the weaknesses of using EBITDA as an analytical tool. When might it be appropriate to use EBITDA as a measure of cash flow? What incentives are there to misuse EBITDA as a metric?


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