Misunderstood and misused

By Alan Lee & A. Scott Davidson
Illustration : John Sapsford

EBITDA can be seductive, but business value based on it alone can give you indigestion

EBITDA is earnings before interest (I), taxes (T), depreciation and amortization (DA). It has many uses, including as a basis for determining business value and as a measure of ability to fund debt. It is, however, often abused and misunderstood.

EBITDA and business enterprise value — the basics:
Enterprise value (EV) is the value of business before deduction of interest-bearing debt. It is the fundamental building block in determining shareholder or partner values, relative values, transaction pricing and in assessing ability to fund principal and interest debt related payments.

A common approach to determine EV is by taking its normalized EBITDA and applying a multiple to it. The multiple can be market-based — be it derived from comparable mergers and acquisitions transactions in the industry or from trading multiples of comparable public companies. The multiple can also be built up based on company-specific risk factors, comparable returns for comparable risk, industry and economic conditions. In the end, all these factors need to be considered in building an appropriate multiple.

Normalized EBITDA means the average annual EBITDA projected to be earned in the near term (one to three years, sometimes up to five years) using reasonable assumptions and effectively ignoring unforeseeable fundamental changes to the business and extraordinary effects.

For a simple example of EV and the related value of 100% of the issued and outstanding shares of the corporation, please see table above.

Normalized EBITDA is a good starting point in the determination of EV because, ignoring the impact of growth and the requirement to make annual capital equipment expenditures (CAPEX), it is good proxy for the free pre-tax cash flow generated by the business’ operations.

    After applying an appropriate multiple the resulting EV is:

• A simplistic but easily computed, convenient estimate of EV — not equity value — subject to the implicit and explicit limitations in both the normalized EBITDA and the multiple applied.
• A basis for studying the value of the business and a basis for comparing otherwise similar businesses without the impact of: unique capital (debt, leases and preference share) structures; unique income tax effects; historical annual CAPEX and future CAPEX that may create capacity and income growth not reflected in the normalized EBITDA.
• For purposes of debt service analysis, normalized EBITDA provides a measure of the ability of the business ability to pay interest and, to a lesser extent, principal — interest because it is paid out before taxes and perhaps, in short-term worst-case scenarios, before maintenance CAPEX. However, to assess ability to service debt before the DA is a slippery slope in our view.

EBITDA derivatives
Industry-specific derivations of EBITDA include EBITDAX for oil & gas or mining industries (where X represents exploration costs) and EBITDAR for industries where a significant portion of the capital assets are rented, leased or financed, such as the airline industry (where R represents rent/lease payments). EBITDAR sometimes means EBITDA before restructuring charges.

For companies that have significant CAPEX requirements, it is often appropriate to utilize EBITDA less CAPEX as a more accurate proxy of its pre-tax discretionary free cash flow. CAPEX in these cases is that which is required to maintain its operations, as opposed to building capacity. Similar comments apply to industries where a significant portion of the capital assets are rented or leased — a more accurate proxy of its pre-tax discretionary free cash flow is EBITDAR less CAPEX and less lease/rental payments required to maintain its operations. In the telecom and cable industries, EBITDA can be greatly reduced or eliminated by CAPEX requirements in the early years of building a system, but this is not the stable state — one needs to look beyond the build out period to find EBITDA less CAPEX that reflect the sustainable long term pre-tax discretionary free cash flow.

EBITDA is illusory
The EV above determined is only as good as the inputs — the normalized EBITDA and the matching multiple. The old adage of “garbage in, garbage out” remains true. Hence, understanding the inputs is the only way to make use of the product.

In the determination of EV, the multiple applied to the normalized EBITDA must complement the normalized EBITDA — because often, what is not reflected in the one can be accounted for in the other — albeit subjectively. To best match the normalized EBITDA to an appropriate multiple, it is essential to understand the impact of the following questions:

• What growth has been built into the normalized EBITDA or the multiple? Users should be careful not to double-count growth by incorporating it into both the normalized EBITDA and the multiple.
• Are synergies that will be realized by the buyer of the business included in the normalized EBITDA or the multiple?
• Is the normalized EBITDA in nominal or inflation adjusted dollars?
• A buck is not a buck. What is the relative quality of the cash flow implied in the normalized EBITDA or the multiple? Where is the normalized EBITDA on the spectrum of realization risk? Has it been adjusted for the probability of realization?
• When comparing the projected normalized EBITDA to historical EBITDA, have non-recurring items been consistently dealt with?

Is the multiple truly comparable? Has it been engineered to be consistent with the assumptions underlying the normalized EBITDA calculation? The two are inseparably interdependent and can only be assessed in relation to each other. They can exacerbate or moderate the weaknesses of EBITDA-based analysis.

So what cash flow effects are not included in normalized EBITDA? Normalized EBITDA does not reflect, by definition, the following:

• working capital needed to support the growth implicit in the normalized EBITDA or the multiple;
• maintenance CAPEX needed to support the normalized EBITDA at a steady level and growth CAPEX to support income growth implicit in the normalized EBITDA or the multiple;
• income taxes;
• timing of realization — as normalized EBITDA is an average, actual pattern of “when the cash comes” may be very different than the implicitly even assumption built into the EV model.

How can one best ameliorate the above inherent limitations in the EV or debt-service analysis based on normalized EBITDA? The best answer is that it is a very quick way to get one’s initial bearings — use the resulting EV or debt service analysis as only a starting point or a sanity check. Use it in combination with other valuation techniques (discounted cash flow and net-income-based techniques) to ensure more necessary perspectives are brought to bear. It should not be the only basis of analysis.

More sophisticated techniques are beyond the scope of this article, as is an analysis of appropriate multiples to apply to normalized EBITDA. Remember that once capital structure is introduced, comparability dramatically diminishes. The following summary observations put normalized EBITDA analysis in perspective:

• discounted cash flow techniques will pro- vide the most comprehensive overview, including those addressed by net-income- based methods and will specifically account for timing of cash flows, CAPEX, working capital needs and time value of money. It is best used when assessing debt service and impact of leverage on equityholders;
• net-income-based methods will specifically account for net income attributable to equityholders. Depreciation, which is deducted in determining net income, is often a rough proxy for maintenance CAPEX — though often it is an underestimate.

Should it stay?
EBITDA is here to stay. Like fine wine, it is too seductive to be banished and its formulation and ingredients will determine the quality. However, business value based on EBITDA alone will give you indigestion, as will a liquid dinner — no matter how fine the wine.