Thinking Deeper About EV/EBITDA – Graham, Buffett And Beyond

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The Enterprise Multiple, EV/EBITDA is one valuation metric commonly seen in the financial world these days. I can definitely appreciate its merits (as I would cover later), however, upon deeper thinking it does raises many questions. In this article, I would be sharing on my thought process and I would love to hear the thoughts of other readers.

The Enterprise Multiple (EV/EBITDA)

When compared against the P/E multiple, EV/EBITDA would definitely be a much better metric to be used. The reason being that with the P/E ratio, it has a numerator that is forward looking and a denominator that is based on past performance.

Why EV? By using Enterprise Value, it allows us to compare companies that are using different capital structures. Imagine buying two similar assets but financed in different ways. One through a pure equity method and the other through debt financing. At the end of the year, the EPS of latter method would be slightly lower due to the interest expense incurred on the debt. However, the difference in EPS for both assets would not differ greatly. Hence, based on the same market price today, both assets would have roughly the same P/E multiple. Assuming a fair P/E ratio of roughly 10x, using a back envelope calculation, it would show that the fair value of the two assets would roughly be the same too. The question that arises here would be, is it really fair to say that the two assets are valued roughly the same when one was done via a pure equity method while the other is done mainly via debt financing. Hence, by using the Enterprise Value it would account for this and allow us to compare companies of different capital structures.

Why EBITDA? Net Income (Earnings) = EBITDA – D&A – Interest – Taxes. The cost (D&A, Interest, Taxes) stated does not show the true cost of operating the business directly and is rather subjective. Tax are inherent to tax rules and are not exactly related to the profitability of the business. Interest is based on how the firm is being financed, rather than how it is being managed. While D&A are adjustments that finance managers decides, hence the subjectivity. Hence, EBITDA is arguably “better” in the sense that it is directly related to the raw earnings of the business itself.

Furthermore, pitting all the valuation metrics against each other, backtests done by W. Gray, it has shown that buying the lowest decile stocks based on the Enterprise Multiple is by far the best, in terms of the compounding annualised growth rate (CAGR). Through the period of 1964 – 2011, such a strategy has returned approximately 14% in CAGR, outperforming all other metrics and the S&P500, which returned only 9.5% in CAGR. Within the backtest, both EBIT and EBITDA was used when calculating the Enterprise Multiple and whilst the EBIT version did result in a higher CAGR than the EBITDA version, the difference was marginal. However, the winning metric was clear in the sense that the Enterprise Multiple was one that outperforms all other metrics and the index itself.

EV/EBITDA – The Conundrum

Yet if we think deeper about EBITDA, while it allows us to compare companies within different industries, it can be quite ‘dubious’. While it provides us a better comparison say between a heavy-capex and light-capex company, can we truly totally ignore the capex of each company? To sustain the earnings of a business, capex is definitely needed to replace wear and tear even assuming that the company is not in a stage of growth. How could one argue that D&A should be completely ignored when assessing the earnings of the business?

Trumpeting EBITDA … is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a ? non-cash charge. That is nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a ? non-cash expense — a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

2002 Berkshire Hathaway’s Shareholders Letters

Hence, with EBITDA it can be misused by finance managers. Furthermore, looking at past historical cases, it is indeed true where EBITDA was being widely abused as a measure of profitability and performance. Some notable cases are such as WorldCom, where earnings were income were overstated by at least USD9billion which resulted in the largest bankruptcy in US history.

Upon deeper research, this problem of EBITDA could be resolved (probably) using maintenance capital expenditure (MCX) as written by Bruce Greenwald’s book: From Graham to Buffett and Beyond.

Calculate the ratio of Property, Plant and Equipment to sales for each of the five prior years and find the average. We use this to indicate the dollars of Property, Plant and Equipment it takes to support each dollar of sales. We then multiply this ratio by the growth (or decrease) in sales dollars the company has achieved in the current year. The result of that calculation is growth capital expenditure. We then subtract it from total capital expenditure to arrive at maintenance capital expenditure.

Value Investing: From Graham to Buffett and Beyond

While using MCX to account for capex does make sense, it does result in problems especially with companies that are heavily capital intensive such as firms within the basic commodity industry. The problem is that with basic commodity firms, it could result in the growth capital expenditure to far exceed the total capital expenditure resulting in a negative maintenance capital expenditure.

Final Words

As seen from the above, EBITDA seems more like a tool that can be subjected to misuse to improve the profitability and performance of a company. In this article, it is not really about whether using EV/EBITDA is right or wrong but rather there are much more variables at play than just using it as of face value. Perhaps, through this thought exercise, EV/EBIT or EV/(EBITDA-MCX) may be a better option to consider. However, the key takeaway is there is no one metric that is able to assess the company’s performance and ultimately its intrinsic value. It is merely an additional tool for analyst to use alongside his understanding of the company’s underlying fundamental values and the nature of the industry the company is operating within. One should not accept a valuation metric purely because it is the most commonly used, but rather question its strength and weakness to be able to better utilise it as one of the many tools in a valuation exercise.

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