EBIT-DUH: Why EBITDA Matters in M&A Deals

EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization

For better or worse has become a standard measurement of operating cash flow by which one can easily compare different companies.  While most public companies quote value as a price / earnings ratio or look at net income per share, private companies use EBITDA as the best available reasonable proxy for profitability,’ it is a decent - but far from perfect – assessment of free cash flow (the true basis for any real valuation analysis).  

Valuations in most M&A deals are generally communicated as a multiple of EBITDA.  We have talked a lot about how to think about multiples, but we have to address the second half of the equation and look at the pros and cons of EBITDA.

The Good News About EBITDA

Using EBITDA is a quick, easy and efficient way to look at any operating business:

1. Focus on Operating Efficiency: EBITDA attempts to focus on the profitability of a company from its core operations by excluding non-operating items such as interest expense (depends if the company has debt or not), taxes (depends if the company pays tax at the entity level or is a pass through to the owners), depreciation and amortization (both non-cash items), gains and losses from non-core operations and FX losses/gains. This simple metric can give a clearer view of how well a company's core business is performing.
2. Proxy for Cash Flow: EBITDA is generally used as a proxy for ‘free cash flow’ which reflects the basis for valuation analysis as well the company’s ability to repay debt and/or make future investments and is a simple metric for operating profit.
3. Simplicity: EBITDA is a relatively simple metric and is a quick snapshot to calculate and understand compared to other measures of profitability. This makes it useful for quick evaluations and initial assessments of a company's financial health.  
4. Standard Comparability: EBITDA allows for easier comparisons between companies because it standardizes the earnings measurement across all companies.  When comparing companies within the same industry or sub-sector it can differentiate “good” companies from “great” companies.

The Bad News About EBITDA

While simple, EBITDA is not perfect.  There are a bunch of flaws in using EBITDA as the only metric that matters.  EBITDA, in isolation, can be a misleading metric especially for highly levered companies or capital intensive industries.

1. Excludes Important Cash Items: EBITDA excludes critical cash drains on the company (interest and taxes) and does not consider capital requirements (those companies with a lot of depreciation tend to need to make significant capital expenditures to  replace capital assets and add capacity from which to grow).
2. Ignores Working Capital: EBITDA also does not consider required investments in working capital (inventory, receivables, etc.) which for some growth companies can be significant and be a big drain on cash.
3. Not GAAP-Compliant: EBITDA is not a Generally Accepted Accounting Principles (GAAP) measure, which means its calculation can vary between companies and may not conform to standard accounting practices. You will never see EBITDA in any financial audit report.
4. Subject to Adjustments: In just about every M&A deal, the basis for valuation tends to be ‘Adjusted EBITDA”, not simply reported results. If these add-backs, normalizations and adjustments are not included in the analysis, it can be extremely misleading.
5. Subject to capitalization policies: Capitalized expenses should not be included in EBITDA to maximize value.  There is considerable discretion when private companies decide whether to expense certain investments or capitalize them (R&D expenditures, IT development, etc.) which can materially alter reported results.
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In summary, while EBITDA has its uses in certain contexts (such as measuring operational efficiency and comparing different companies across an industry), relying solely on it for company valuation  will  lead to incomplete or misleading conclusions about a company's financial health and long-term prospects.

Conclusion

For better or worse, EBITDA is the basis for all private company valuations.  As such, we highly recommend that owners and management team have a dedicated focus on EBITDA as one of the key metrics that matter.  It should be tracked on a monthly basis, and include all normalizations and adjustments as a simple measure of profitability and efficiency, without the noise of accounting or financing issues.

Contact Us

Feel free to contact us to discuss how we can help you explore the challenges and opportunities of using EBITDA further.  

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