EBITDA: Does it still do the job?
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.
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.
“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.”