EBITDA: Does it still do the job?

EBITDA
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It’s a bit of a mouthful, but EBITDA (earnings before interest, tax, depreciation, and amortisation) has been one of the most widely used metrics in finance since the 1980s.

It has attained this ubiquity despite not being recognised under the International Financial Reporting Standards (IFRS). Rather, as the FRC explained to AccountingWEB, it can be thought of as a presentation of management’s view.

By stripping away non-operational expenses, EBITDA, in theory, allows for easier analysis of a company’s core profitability. The measure became popular in the late 90s because it proved to be a useful valuation tool during the dizzying dotcom bubble for loss-making tech businesses.

The dotcom bubble burst, but EBITDA remained. According to the London Business School’s Chris Higson, it has become something akin to a cult. “EBITDA is part of the story,” Higson wrote. “However, and worryingly, EBITDA has become the story for many companies, analysts and commentators.”

As it happens, there’s currently an IFRS project looking at the possible disclosure of a ‘management performance metric’ on the face of the financial statements, which would be based off a more standardised format.

But that’s looking ahead into the future. A metric like EBITDA is still with us, and while it is, it’s worth asking what its uses and weaknesses are.

Depreciation blues

Higson’s criticism is focused on the 'DA' part of the metric. By omitting depreciation and amortisation, he argued, you’re ignoring a very real cost. It’s a misgiving that Jeremy Hunt, the CFO of InvestorConnected echoes.

“EBITDA is there to say how profitable the underlying core of the company is,” Hunt said. “Where EBITDA loses value is because companies inherently are set up in certain ways. So you might have large amounts of machinery depreciating over time or have large loans.

“Now, when you take external investors into account, they often have the ability to change stuff that comes after the line, after EBITDA. They could, for instance, write off a loan or provide extra funding so you don’t need a loan.”

EBITDA, Hunt explained, will show whether the core operations are profitable, but once you consider how the business is structured and how it comes to be where it is today, that’s when you have to broaden your insight.

“A lot of people will use net profit to get a better idea of a business’s profitability,” Hunt said.

But EBITDA remains useful, said Hunt’s co-founder Thierry Clarke because net profit doesn’t take into account that some businesses want to operate at a loss. “EBITDA isn’t messed around by leverage and other operational lines that go through the P&L.”

EBITDA remains one of Clarke’s core valuation methodologies, but some startups have gone sour on the measure. For businesses where their valuation relies heavily on intellectual property (IP), EBITDA doesn’t adequately reflect their scaling potential.

Valuation tool

“We’re valuing the business very highly depending on what we think it will scale to, much higher than a few multiples of EBITDA,” said Alasdair McGill, the FD of the new social network Miigen. McGill is currently shepherding the business through its next funding round which is likely to raise north of £1m.

According to McGill, EBITDA is a metric that Miigen tries not to use. “In this funding round with Miigen, we’ve calculated what we think the EBITDA might be but we don’t want investors focused on it. We’ve had to use it to respond to a question but we don’t think the value will lie there for anyone.”

For Caroline Plumb, the founder of Fluidly, a VC-backed intelligent cashflow tool, valuation is much more than just the numbers. “You need to look at the business, its maturity, its growth rate, the intellectual property, the wider market. It’s never just a function of one thing. The multiples of EBITDA vary widely depending on those factors.

“It doesn’t make sense to use EBITDA as a valuation metric because it’s essentially a backward-looking measure. It tells you about a period of profitability that happened in the past. A valuation is borne of your current assets and how you can commercialise those.”

But EBITDA’s popularity endures, despite its increasing inadequacy. “I trained with EY in the 80s, and the way we measure things now is exactly the same,” said Miigen’s McGill. “The problem is that people don’t know anything else. It’s trying to find examples of businesses that are valued differently. We’re still trying to answer that question ourselves.”

About Francois Badenhorst

Francois

I'm AccountingWEB's business editor. Feel free to get in touch with comments, tips, scoops or irreverent banter. 

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06th Mar 2018 12:39

Charlie Munger (Warren Buffet's number 2) described it as b*llsh*t earnings because it ignores the worst costs of a business namely those that are paid up front such as plant and equipment,licenses. It encourages short term performance rather than return on capital. Let's consign EBITDA to the 1980s.

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to Knight Rider
06th Mar 2018 13:35

Thanks for the comment, Knight Rider. Yeah, Buffett himself is extremely bearish on EBITDA, too. Does the measure have any redeeming qualities, do you think? Even as just a nifty measure.

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to Francois Badenhorst
06th Mar 2018 16:22

I can imagine Ken Morrison not being very kind to EBITDA as well. Used in isolation it could encourage the wrong behaviour - taking on debt to boost EBITDA while reducing profit for example. Perhaps it may be OK when used with other measures such as ROCE.

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By tom123
06th Mar 2018 13:12

Fundamentally, for me, EBITDA is an external measure to value other businesses.

For day to day control of one's own company, we do not tend to use it at all. After all, our loan costs, or capital replacement, are very real costs to us.

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to tom123
06th Mar 2018 13:33

Thanks, Tom!

Warren Buffett has quite a funny quote referencing this exact point: “Does management think the tooth fairy pays for capital expenditures?”

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08th Mar 2018 13:36

EBITDA is closer to 'cashflow from operating activities', I.e. if your corporate focus is on FCF. Investing activities (incl capex) can be tweaked/controlled separately. Internally it can create a myopia, big movements below the line (e.g. foreign exchange gains/losses) not managed by a central dept are ignored by operational management who's actions influence the line.

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By keithas
08th Mar 2018 12:02

If you're looking for a single measure which can be used to compare all businesses, then good luck with that.
But to question EBITDA is about as valid as questioning the value of Turnover, Gross Profit, Net Profit before Tax or any of the myriad values which, when used in context, impart useful information about an enterprise.

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By ASF
08th Mar 2018 12:16

Can't see how one figure would do anything other than over-simplify. Like others, we don't even think of EBITDA internally, but instead use GP%, NOP%, Sales Growth %, cash flows and ETR % to try and monitor key measurement variables. If we are not sustaining or growing activity and profit levels, and can't pay the bills, we are toast, and EBITDA would only distract us. Understand perfectly the outside world's desire to have a handy little metric, but not the way an ongoing business should be run, in my opinion!!!

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08th Mar 2018 12:50

Net cash generated and net profit are two better measures which take account of the cost of capex - one when paid for, the other spread over its life. EBITDA on the other hand ignores capex altogether.

An EBITDA focus rewards fixed asset policies that capitalise everything no matter how small or how short a life. This can also encourages purchase arrangements that repackage opex as capex.

Mr Buffet, as usual, nails it.

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to ngretton
08th Mar 2018 14:54

Thing is, multi national corporates who performance manage their operations using this metric, also tightly control capex, indeed tweaking the latter down, if the former is struggling to maintain cash targets.

Quite often you see $5k de minimis or stiffer on any capitalisation treatment, I.e. don't come a knocking for a fixed asset number unless the item is >$5k.

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08th Mar 2018 13:25

TBH you have to wonder whether any of the information in any statutory accounts is worth anything. Look at the likes of Carillion and Tesco and it's clear the accounts don't actually represent reality.

If auditors were truly independent then we might put more faith in them but when auditors rely on companies for their income then this independence is compromised and the resulting information becomes worthless at best and misleading at worst.

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By edhy
09th Mar 2018 08:19

The article is focusing in wrong direction.

EBITDA is not a measure to gauge Profitability, it is measure for ability to repay interest / loans and used by creditors. EBITDA is close to liquidity if working capital composition remain "same", funds that would be available to repay loans and capex.

As to valuation of a business EBITDA multiple is simply foolish. The measure should be DCF of future cash. EBITDA is not designed for Profitability nor Valuation, so it is not EBITDA's fault but of people using wrong tool.

As to the real costs not only Depreciation but also Interest and Taxes are real, does any one doubts tax are real.

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to edhy
09th Mar 2018 10:03

Hear, hear.

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to edhy
11th Mar 2018 22:08

+1
It is used by creditors. NatWest, for example, use EBITDA minus dividends as the metric for deciding whether a business can afford to take on more debt. They recently told a client of mine that EBITDA less dividends must equal at least 1.75 x annual debt cost. Not sure how that compares to other lenders, but that is not really relevent.

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13th Mar 2018 11:09

Any measure of profitability/ performance is worthless in isolation, there are lots of other measure contained in the Accounts, cash flow statements, balance sheet totals, Liquidity ratios......

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