EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

Investors in public companies have historically evaluated them on reported earnings.

By contrast, private buyers of entire companies have valued them on free cash flow.



Historical

In the latter half of the 1980s, entire businesses were bought and sold almost as readily as securities, and it was not unreasonable for investors in securities to start thinking more like buyers and sellers of entire businesses.

In a radical departure from the historical norm, many stock and junk-bond buyers in the latter half of the 1980s replaced earnings with cash flow as the analytical measure of value.

In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number, that would quantify a company's cash-generating ability.  The cash-flow calculation the great majority of investors settled upon was EBITDA.

Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant.  

Even non-leveraged firms came to be analysed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate.  

Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.





How should cash flow be measured?

Before the junk-bond era investors looked at two components: 

• after tax earnings, (that is the profit of a business); plus 
• depreciation and amortization minus capital expenditures (that is, the net investment or disinvestment in the fixed assets of a business.)

The availability of large amounts of non-recourse financing changed things.  

Since interest expense is tax deductible, pretax, not after-tax, earnings are available to pay interest on debt; money that would have gone to pay taxes goes instead to lenders. 

A highly leveraged company thus has more available cash flow than the same business utilizing less leverage.


Notwithstanding, EBIT is not necessarily all freely available cash.

• If interest expense consumes all of EBIT, no income taxes are owed.
• If interest expense is low, however, taxes consume an appreciable portion of EBIT.

At the height of the junk-bond boom, companies could borrow an amount so great that all of EBIT (or more than all of EBIT) was frequently required for paying interest.  

In a less frothy lending environment companies cannot become so highly leveraged at will. 

• EBIT is therefore not a reasonable approximation of cash flow for them.  
• After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream.

Depreciation

Cash flow, also results from the excess of depreciation and amortization expenses over capital expenditures.  It is important to understand why this is so. 

• When a company buys a machine, it is required under GAAP to expense that machine over its useful life, a procedure known in accounting as depreciation.  
• Depreciation is a noncash expense that reduces net reported profits but not cash.  
• Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment.  
• Capital expenditures are thus a direct offset to depreciation allowances; the former is as certain a use of cash as the latter is a source.  

The timing may differ: a company may invest heavily in plant and equipment at one point and afterward generate depreciation allowances well in excess of current capital spending. 

• Whenever the plant and equipment need to be replaced, however cash must be available.  
• If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

Amortization

Amortization of goodwill is also a noncash charge but,conversely, is more of an accounting fiction than a real business expense. 

When a company is purchased for more than its tangible book value, accounting rules require the buyer to create an intangible balance-sheet asset known as goodwill to make up for the difference, and then to amortize that goodwill over forty years. 

• Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely need not be spent in the future to preserve the business. 
• Charges for goodwill amortization usually do represent free cash flow.

Why was EBITDA used?

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. 

• EBIT did not accurately measure the cash flow from a company's ongoing income stream.  
• Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.  

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.  

• In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipate sharp reductions in capital expenditures.  
• Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

What is the required level of capital expenditure for a given business?

It is not easy to determine the required level of capital expenditures for a given business.  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.

Capital expenditures made for diversification are often not necessary at all.  

Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders.  

Since detailed capital-spending information are not readily available to investors, perhaps they simply chose to disregard it.

EBITDA by ignoring capital expenditures is flawed

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because ALL the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). 

• One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment int he business.  

This view was flawed, of course. 

• Leasehold improvements and parts of a machine are not typically financeable for any company.  
• Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.   
• An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

EBITDA:  a clear case of circular reasoning to justify high takeover prices

EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. 

This would be a clear case of circular reasoning. 

• Without high-priced takeovers there we no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.  
• This would not be the first time on Wall Street that the means we adapted to justify an end.  
• If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.