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April Fooled By EBITDA

EBITDA is one of the most common financial terms that we come across in equity research reports. It is one of those metrics which analysts often use to measure a company’s ‘cash’ operating earnings. EBITDA multiples (e.g. EV/EBITDA) are regularly used to estimate if a business is cheap or expensive…however nothing can be as misleading as an EBITDA in gauging how strong the business performance actually is….nothing in the financial world can come even close in terms of ‘uselessness’.

EBITDA stands for ‘Earnings Before Interest, Tax, Depreciation and Amortisation’. This is used as a proxy for the cashflow from the operating business by removing the effects of the non-cash expenses like Depreciation and Amortisation… and also by ignoring the effects of the financing structure (how a business is being financed… Equity or a combination of Debt & Equity), by not including interest expenses. The EBITDA also does not get affected by the particular tax structure of the jurisdiction where the business is operating. The rational is that the users of EBITDA want to evaluate the core operations and that should not be contaminated by the financing structure or the tax structure of the business. The existing owners (or a new buyer of the business) always have the option of modifying the financing structure by changing the debt/equity ratio… or not have any debt on their balance sheet at all. Also the Tax expenses or the govt’s share of the profits should not be a factor in evaluating how strong the core  operations of the business is. 

Calculating the earnings power of an un-levered (assume no debt) business without bothering about the financing structure of the business or the tax payable, has a strong justification… it gives us a good idea of how much money the actual operating business is making. The operating earnings (or EBIT… Earnings Before Interest and Tax) is a good way to compare the operations of two similar businesses.

However here some of the serious flaws of using a metric like EBITDA

  1. Depreciation is a real cost which a business cannot avoid. A business typically uses some property, plants & machinery to run their operations…and with continuous use, these lose value due to wear and tear. This expense is captured in form of depreciation (till the time when they have no more value left). Just because the business is not incurring a cash outflow for this particular expense, doesn’t mean that this expense does not exist. The EBITDA metric fails to realise this reality.

  1. Now even though the Depreciation of the PP&E is a non-cash expense, to replace the PP&E that has been used up, a business would on an ongoing basis need to make capital expenditures. The capital expenditure (CAPEX) can be in form of purchasing new plant/machinery or office furniture, equipments or company vehicles… these do not show up in the  income statements, but these capital expenditures get added to the asset side of the balance sheet… in form of addition to the PP&E. The EBITDA does not capture this capital expenditure as well. So it is like an Ostrich with it’s head buried in the sand… which is not bothered with either the capital expenditure or the ongoing depreciation… as if these do not matter.

Fig: A simplistic view of the PP&E and Depreciation (straight line)

For example…two different businesses A and B…where A is an asset heavy business which requires a lot of capital expenditures on an ongoing basis and as a result the depreciation expense is quite high…and B is an internet based business which is very asset light and does not need to spend much on capital expenditures at all. Looking just at the EBITDA or at EV/EBITDA multiples, it is possible that this important difference between the two businesses is completely lost. The EBITDA multiples of the two businesses could appear to be similar… which is totally misleading.

  1. Similarly a business with lot of intangible assets (for example software licenses, patents etc) which have a fixed life, would incur yearly Amortisation expenses. At the end of the life of these intangible assets, the business needs to replace some of these intangibles by incurring additional CapEx. The EBITDA does not capture this reality too and is fairly useless in situations like this.

  1. The other issue with EBITDA is that it does not pay any attention to the changes in the working capital that goes in running the operations. A business might be growing their revenues very fast, but if they are not being able to collect their outstanding receivables on time… or if to grow their revenues they need to grow their inventory even faster, then the growth in revenues will not translate into growth in actual earnings for the owners (Owners Earnings or Free Cash Flow). The increase in the receivables and inventory means the business sucks in more and more working capital to run the operations. This problem is  completely overlooked by those who use the EBITDA as a proxy of the cashflows.

So to summarise you can have a business that is growing revenues very fast but…

  1. Consume a lot of CapEx (and as a result have high depreciation expenses)

  2. Have a deteriorating Working Capital situation… receivables are not being collected on time… unsold inventory growing faster than growth in revenues

The EBITDA of a business like this will show very healthy growth, deceiving lot of inexperienced investors, who will fall for such an ‘attractive business’ looking at the EV/EBITDA multiples… but in reality, it could be a very bad investment… the truth will be hidden in the deteriorating Free Cash Flows and nothing will be left for the owners to take home.

No wonder Charlie Munger expressed Berkshire Hathaway’s position on EBITDA  with this statement : “I think that, every time you see the word EBITDA, you should substitute the words ‘bullshit’ earnings.”

Look out for the Part 2 of this 2-Part series, where I will discuss a detailed case study with all the numbers highlighting the problems of focussing on EBITDA.

There are some more issues in using EBITA, and they come up when one tries to capitalise the operating leases of a business. Capitalising Operating leases is a way to capture all the outstanding contractual obligations (future rent payments) of the business, which are currently not shown on the balance sheet. By capitalising the operating leases, we bring all such contractual obligations on the balance sheet, and get a clear picture of the present value of all such obligations. We keep this discussion for a subsequent post (Note: some recent changes in accounting rules will do away with this requirement for capitalising,  as operating leases will also be captured on the B/S right away…which is a good thing).

 
 
 

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