Popular as EBITDA is, here are some issues associated with using EBITDA that every investor should know.
What is EBITDA?
EBITDA stands for Earnings before Interest, Tax, Depreciation and Amortisation. By removing these expenses, EBITDA is commonly believed to be a proxy for free cash flow. In that regard, it allows investors to evaluate the cash-generating ability of companies.
As with every measure, EBITDA does have its flaws even if little heed is typically paid to it.
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Non-Cash Does Not Mean Non-Economic
The main issue with EIBTDA lies in the omission of depreciation. While this may be acceptable for service-based businesses, depreciation is a very real, albeit non-cash, expense for the majority of businesses. Machines get worn out and need to be consistently maintained for the business to be sustained. Depreciation expenses must eventually be used to fund capital expenditures. A manager who distributes the ‘excess’ cash from depreciation will find himself in a bind when that day comes.
Favours Self-Owned Assets
Consider the case of 2 identical retails stores which each make $100 of sales annually. Cost of goods sold incurred takes up $50, resulting in $50 of gross profits. Store A bought their premises for $100 which is expected to have a useful life of 10 years. This implies an annual depreciation of $10. Store B, on the other hand, rents their premises for $10 a year.
Both stores will have similar net incomes of $40. However, the EBITDA of Store A is $50 while Store B’s is $40. Under the EBITDA approach, Store A would be erroneously perceived to be more profitable. In fact, anyone familiar with the time value of money would prefer paying $100 over 10 years to paying $100 upfront as in the case of Store A. In this scenario, Store B is the better pick.
A failure to understand EBITDA might result in overpaying for a business. This is especially pertinent to asset-heavy industries where depreciation constitute a very large portion of expenses. They may have very high EBITDA and trade at relatively low EBITDA multiples (e.g. EV/EBITDA). However, all of the EBITDA will be used for reinvestment. Free cash flow usually turns out to be anaemic and equity holders receive next to nothing for their capital.