EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow.
Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business.
Service Company X
(millions)
Revenue $100
Cash Expenses 80
Depreciation and Amortization 0
___________________________
EBIT $20
___________________________
EBITDA $20
Manufacturing Company Y
(millions)
Revenue $100
Cash Expenses 80
Depreciation and Amortization 20
____________________________
EBIT $0
____________________________
EBITDA $20
Investors relying on EBITDA as their only analytical tool would value these two businesses equally.
At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing.
Although these businesses have identical EBITDA, they are clearly not equally valuable.
Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery. It has no free cash flow over time.
The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.
Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business.
Service Company X
(millions)
Revenue $100
Cash Expenses 80
Depreciation and Amortization 0
___________________________
EBIT $20
___________________________
EBITDA $20
Manufacturing Company Y
(millions)
Revenue $100
Cash Expenses 80
Depreciation and Amortization 20
____________________________
EBIT $0
____________________________
EBITDA $20
Investors relying on EBITDA as their only analytical tool would value these two businesses equally.
At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing.
Although these businesses have identical EBITDA, they are clearly not equally valuable.
- Company X could be a service business that owns no depreciable assets.
- Company Y could be a manufacturing business in a competitive industry.
Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery. It has no free cash flow over time.
- Anyone who purchased Company Y on a leveraged basis would be in trouble.
- To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when the plant and equipment needed to be replaced.
- Company Y would eventually go bankrupt, unable both to service its debt and maintain its business.
- Company X, by contrast, might be an attractive buyout candidate.
The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.
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