In the business valuation process, many Wall Street firms and investors have used EBITDA as a measure of business cash flow, and EBITDA multiple to determine the appropriate valuation of the business. However, there are other opinions that EBITDA is often a misleading number for real business operating performance. Let’s take a closer look to see whether we should use EBITDA in our valuation process.
What is EBITDA?
EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. Thus, EBITDA is derived by adding back to net income interests and taxes payments, as well as depreciation and amortization expenses. Many investors who have used it reason that EBITDA is used to assess the business operating profitability, as interest, taxes are nonoperating expenses and depreciation and amortization are noncash charges. Most dealmakers often use EV/EBITDA multiple (EV represents Enterprise Value, which is calculated by adding back debt to and subtracting cash from the company’s market value) to value attractiveness of a merger and acquisition deal.
Not a realiable number to true business earnings
Nevertheless, EBITDA has many flaws in computing true business earnings. It excludes the depreciation expense, one of the really true business expenses, from the calculation. For example, company A earns nothing but has the depreciation expenses of $5 million and will be valued equally with company B, which earns $5 million but has no depreciation expense. Company A might be the manufacturing business with a lot of assets; thus, it has the depreciation expense while company B is the service business, having no assets to be depreciated. To maintain its competitiveness, company A, at some point, has to invest more into the business when its factories and machines wear out.
Seth Klarman (Trades, Portfolio), in his famous book "Margin of Safety," has said, "Businesses invest in physical plant and equipment for many reasons: to remain in business, to compete, to grow and to diversify. Expenditures to stay in business and to compete are absolutely necessary. Capital expenditures required for growth are important but not usually essential while expenditures made for diversification are often not necessary at all."
Warren Buffett (Trades, Portfolio) also compared depreciation as “reverse float,” meaning that the money was to be laid out before we receive any cash. Depreciation is not the noncash expense, but the expense that we have to spend it first. “It’s a delayed recording of a cash expense.” His long-term partner, Charlie Munger (Trades, Portfolio), called EBITDA “bullshit” earnings. To his views, interest and taxes are real business operating costs.
In terms of capital expenditure, as Klarman put it, there are two kinds: maintenance capex and growth capex. In order to get to the true free cash flow figure, investors need to subtract maintenance capex. Normally in companies’ reports, they don’t break down those two capex separately. We can assume that the deprecation number is roughly equal the maintenance capex, which businesses need to reinvest to maintain its positions in the market.
In the 2013 annual letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), Warren Buffett (Trades, Portfolio) has showed his opinion on EBITDA valuation: “Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.”
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