In the past year there have been a number of articles criticizing EBITDA and a multiple thereof to determine a company’s value. EBITDA is an acronym for “earnings before interest, taxes, depreciation, and amortization.” It has been used extensively since the 1980’s as a quick measure of company’s profitability and cash availability by banks, investors, and mergers and acquisition companies. Today it is widely used to value a business (expressed as a multiple of EBITDA) and summaries are compiled on transactions stating what the multiple range is for various business types. Annual and quarterly comparative statistics are presented on the EBITDA multiples for industry types and sizes of businesses.
The popularity of this measure has been earned because it is a figure that is easily calculated, easy to explain, and the information is readily available from basic financial statements. The calculation of the EBITDA figure has recently come under some criticism by not only banks and financial institutions, but by the Mergers & Acquisitions Industry themselves. In an article in the August 2008 issue of Mergers and Acquisitions Magazine called “Refining EBITDA” and they pointed out the problem of its use in their subtitle - “Who knew EBITDA had so many definitions?” This concern has largely been triggered by the misuse of the metric, lack of completeness, and factors not revealed or taken into consideration in its impact on value.
In determining valuation of a company, EBITDA is lacking some important factors that may lead to overpayment by a buyer or over pricing by a seller, causing interested buyers to be unable to get financing.
Some of these factors are:
1. EBITDA is not cash flow
2. It does not show the actual cash available to service debt
3. It is not a good multiple in comparing companies as depreciation and amortization treatment can vary between companies
4. It does not include changes in long-term debt
5. It does not show the cost of debt
6. It does not show the impact on working capital
7. It does not show the impact of taxes
8. It does not show the impact of needed capital expenditures
9. It does not represent the amount of cash available to investors
There are probably others, but the key factor presented here is that it does not truly reflect the availability of cash and the ability of the company to service debt and sustain its operations and growth potential. We are also reminded that the value of business is largely determined by the generation of its future earnings and cash flows and not its historical performance. The future value of a company impacted, not only by the economy, but also by capital expenditures, working capital needs, loans, and investor/owner returns that are not covered in EBITDA calculations.
To correctly identify and take into account these deficiencies we not only prepare a normalized EBITDA summary, but also calculate the Company’s Free Cash Flow (FCF) metrics that cover the deficiencies of EBITDA. This is performed at two levels, one is FCF to equity (FCF-E) and the other FCF to total invested capital (FCF-TIC).
FCF-E is calculated as follows:
Net Income
Plus Non-Cash Charges (depreciation & Amortization)
Less Capital Expenditures
Less changes in Working Capital
Less changes in interest bearing debt
Less Dividend Payments (preferred)
Equals Cash Flow available to Equity
FCF-TIC is calculated as follows:
Net operating income
Less taxes
Plus non-cash charges (depreciation and amortization)
Less Capital Expenditures
Less Changes in working capital
Equals Free Cash Flow to Total Invested Capital
By providing both EBITDA and FCF figures it gives the buyer, seller, and financing providers a clear understanding of the ability of the company to generate cash and compare this ability to the needs of the Company and to compare with the generally used EBITDA figures. Valuation figures are typically based on the net present value of discounted future earnings and cash flow and the use of both methods allows for better understanding of value and the impacts on value of cash needs for future operations.
