The Critical Flaws of EBITDA

 

Thursday, 9 January 2020

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

https://myinvestingnotes.blogspot.com/2020/01/ebitda-analytically-flawed-and-resulted.html

Summary for Investors: The Critical Flaws of EBITDA

Bottom Line Up Front: EBITDA is not free cash flow. Using it to value businesses will likely cause you to overpay for stocks, because it ignores two critical cash expenses that every real business must pay.

The 3 Fatal Flaws of Using EBITDA as a Valuation Tool:

1. It Ignores the Cost of Staying in Business (Capital Expenditures - "CapEx")

   • Problem: EBITDA adds back all depreciation (the accounting cost of assets wearing out) but doesn't subtract the actual cash needed to replace those assets (CapEx).

   • Reality Check: A factory's machines will wear out. A delivery fleet will need replacement. If you spend depreciation cash on dividends or debt payments instead of new equipment, you are liquidating the company slowly.

   • Investor Takeaway: A company with high EBITDA but no profits and high CapEx needs may be a value trap.

2. It Ignores Taxes (A Very Real Cash Expense)

   • Problem: EBITDA pretends taxes don't exist. For any profitable company not buried in debt, taxes are a major, unavoidable cash outflow.

   • Reality Check: "Earnings Before Interest and Taxes" is exactly that—it stops before the taxman gets paid. Your share of the profits is what comes after taxes.

   • Investor Takeaway: Valuing a company on pre-tax cash flow will systematically overstate the cash available to shareholders.

3. It Was Popularized to Justify Unsustainable Prices & Debt

   • Historical Context: In the 1980s LBO boom, bankers and analysts used EBITDA to make sky-high takeover prices and dangerous debt levels look affordable. It created a circular logic: high prices required a new metric to justify them.

   • Reality Check: Be skeptical of metrics that suddenly become popular during market manias. They often exist to enable deals, not to reveal truth.

What You Should Look At Instead: Free Cash Flow (FCF)

The Article's Formula for True Owner Earnings:
Free Cash Flow = After-Tax Profit + Depreciation & Amortization - Capital Expenditures

• This is the cash a business actually generates after covering the essential costs of running and maintaining itself. This is the cash that can be paid to you (dividends/buybacks), used to pay down debt, or reinvested for growth—without harming the business.

Smart Investor Action Steps:

1. Always Look Beyond EBITDA. See it as a very rough starting point for understanding operating performance, never as a final measure of value or cash generation.

2. Calculate and Focus on Free Cash Flow (FCF). This is the single most important metric for assessing a company's financial health and its ability to reward shareholders. You can find the components easily on any cash flow statement.

3. Scrutinize the Cash Flow Statement. The "Cash from Operations" and "Capital Expenditures" lines tell the real story. A company with strong, growing Cash from Operations after CapEx is creating genuine value.

4. Be Wary of "Adjusted EBITDA." This is often an even more aggressive version where companies add back other "one-time" expenses. Always ask: "Is this a real cash cost the business will likely face again?"

Final Thought: Warren Buffett famously prefers to value businesses based on their "owner earnings," which is essentially their free cash flow. His partner Charlie Munger has called EBITDA "bullshit earnings." As an investor, your goal is to think like an owner buying the entire business. Ask yourself: "After all the bills are paid—including for new equipment and taxes—how much cash is left for me?" That's the number that matters. EBITDA deliberately obscures that answer.

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Here is a list of the main points, followed by discussion, commentary, and a summary.

Main Points of the Article

1. Historical Shift in Valuation: In the late 1980s, public market investors began imitating private equity buyers by shifting from valuing companies based on reported earnings to valuing them based on cash flow.

2. The Rise of EBITDA: In this shift, investors sought a simple, single-number proxy for cash flow. They widely adopted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), especially for leveraged and takeover-target companies.

3. The Core Flaw: EBITDA is analytically flawed because it ignores essential cash outflows:

   • It adds back all depreciation, but fails to subtract necessary capital expenditures (CapEx) needed to maintain the business.

   • It ignores taxes, which are a real cash cost for any company not solely financed by debt.

   • It treats amortization of goodwill as a non-cash add-back, which, while often justified, further inflates the cash flow figure.

4. Correct Cash Flow Measure: True free cash flow should be measured as:

   • After-tax earnings (profit), plus

   • Depreciation & Amortization, minus

   • Capital Expenditures (the net investment in the business's assets).

5. Why EBITDA Was Embraced (Despite Its Flaws):

   • Simplification & Laziness: It was a easy, single-number heuristic; detailed CapEx analysis is complex and requires insider knowledge.

   • Leveraged Buyout (LBO) Justification: In the high-leverage environment of the 1980s, with tax-deductible interest, pretax cash flow (like EBIT) became more relevant to debt service. EBITDA extended this logic dangerously.

   • Circular Reasoning for High Prices: EBITDA allowed analysts and deal-makers to justify ever-higher takeover prices and fees that traditional metrics could not support. The metric was adapted to serve the desired outcome (making deals happen).

6. The Dangerous Consequences: Using EBITDA led to chronic overvaluation.

   • It assumed businesses could operate without reinvesting in their physical assets.

   • It created a false sense of safety for lenders and bondholders, as companies spending depreciation on debt service instead of CapEx faced eventual decay, distress, or bankruptcy.

Discussion & Commentary

The article presents a timeless and crucial critique of a metric that remains pervasive today. Its arguments are powerful and largely correct:

1. Enduring Relevance: The critique is not just historical. "Adjusted EBITDA" and the misuse of EBITDA continue to be points of contention, especially in high-growth tech, telecom, and leveraged industries. The article's warning that ignoring maintenance CapEx leads to a "gradual liquidation" is a fundamental truth of corporate finance.

2. The CapEx Fallacy: The point on capital expenditure is the most critical. Depreciation is an accounting estimate of asset consumption, while CapEx is the actual cash spent to offset it. Assuming they match is optimistic; assuming CapEx can be zero (or fully financed forever) is reckless. The article correctly frames this as a survival-level expense.

3. Context Matters: The article astutely notes that EBITDA's utility is context-dependent. It was less nonsensical for a specific late-80s LBO model where:

   • The capital structure was designed to maximize tax shields.

   • The plan involved aggressive asset sales or operational turnarounds.

   • However, using it as a universal valuation metric for public equities was the fatal error.

4. Modern Nuances: Today's discussion would add:

   • Goodwill & Intangibles: For modern businesses (software, brands), amortization of other intangibles (patents, customer lists) and investments in expensed intangibles (R&D, marketing) complicate the picture further. EBITDA fails here too.

   • Working Capital: A complete free cash flow measure also requires adjusting for changes in working capital (inventory, receivables, payables), which the article's simplified formula omits but is vital for a full picture.

5. Broader Lesson on Metrics: The article is a masterclass in how Wall Street can adopt "innovative" metrics that serve transaction volumes and fees rather than rigorous analysis. It warns against the seduction of simple answers to complex questions (like "what is this business's cash-generating ability?").

Summary

This article is a critical analysis of the rise and misuse of EBITDA as a valuation tool during the 1980s leveraged buyout boom. It argues that investors, eager to mimic private buyers and simplify analysis, erroneously adopted EBITDA as a proxy for free cash flow. This was a profound analytical error because EBITDA ignores capital expenditures (necessary to maintain the business) and taxes (a real cash cost), leading to the systematic overvaluation of companies.

The piece explains that true cash flow is derived from after-tax earnings, adjusted for depreciation minus capital spending. It posits that EBITDA gained traction due to a combination of simplicity, its usefulness in justifying high leverage and tax strategies, and, most cynically, circular reasoning—it was the only metric that could rationalize the soaring prices and lucrative fees of the takeover era. The ultimate consequence was a misallocation of capital into businesses whose claimed cash flows could not be sustained without vital reinvestment, risking their long-term health and stability. The critique serves as an enduring warning about the dangers of flawed financial metrics.