The last post addressed EBITDA’s “Naughty 11” Problems and What to Do About Them. Today we talk about EBITDA’s “11 goodies” that help counter the “naughty 11” problems and make it a useful tool for analysts, operators, and owners. In the end, there is no single magic measure of cash flow that reveals all about business value.  EBITDA, however, is one measure of cash flow that deserves attention in terms of valuation-related analysis, but in the context of solid reviews of historical income statements, balance sheets, and cash flow statements with insights about history and outlook from management.

One common way to develop EBITDA is shown in the figure below.

The beginning point of the discussion of EBITDA is sales. A famous quote attributed to a number of people is that “Nothing happens until somebody sells something.” Without sales, there is no EBITDA or any other measure of cash flow.  From sales, subtract all operating costs of sales (other than interest and taxes) to arrive at operating income, which, of course, is one measure of cash flow.  Now add depreciation and amortization expense to operating income and we arrive at EBITDA, which we call a measure of gross cash flow.

The First Seven Good Things of EBITDA

EBITDA is the source of most of the things that stakeholders of businesses need or desire. Seven important stakeholder benefits flow from this source of gross cash flow.  The figure below puts these seven “goodies” into perspective.  Following the figure, we will discuss each of them.

EBITDA reflects current period gross cash flow.  The figure shows other sources of discretionary cash inflows to a business for completeness.  These include new borrowings, the sale of stock, or the sale of assets. Absent these discretionary inflows, these new inflows are of interest to management, boards, and of course, shareholders.

The first seven good things about EBITDA are reflected in the numbered columns.

1. EBITDA is a source to pay interest on debt to lenders.  Companies with leverage have mandatory interest payments that must be made when due each period.  Some think that interest expense is paid from EBIT, which, of course, it is. However, for every EBIT, there is a DA (depreciation and amortization) that is part of each company’s gross cash flow.
2. EBITDA is the source to pay applicable taxes.  Taxes are based, for the most part, on a company’s periodic income, although all other taxes are paid from this cash flow source. C corporations are tax-paying entities and must, of course, pay their federal and state taxes.  Pass-through entities are flow-through entities and flow shareholder level taxes through to their owners. Shareholder-level taxes are included in this item of cash outflow.
3. EBITDA is the source to repay principal on debt owed to lenders when it is due.  Columns #1 and #2 reflect mandatory cash outflows for a business each period.  Principal repayments are, for the most part, mandatory, as well.  There may, however, be some discretion involved in the timing and amounts of principal repaid, as indicated in column #3 at the bottom. Management, boards, and shareholders are all interested in the timely repayment of debt.

Columns #4 through #7 are indicated to be discretionary outflows of cash. While some of these items may not be discretionary in the longer run, they are generally discretionary regarding amounts and timing.

4. EBITDA is the source of needed working capital requirements. While working capital can sometimes be provided temporarily from balance sheet sources, the primary source for working capital needs associated with growth is the retention of periodic cash flow to finance inventories, receivables and other (net) working capital needs.
5. EBITDA is the source of replacement capital expenditures. We break capex into categories here and focus first on replacement needs. Every company’s investment in plant or equipment or computers or vehicles or whatever depreciates in the physical sense.  The depreciation in EBITDA is the first source for replacement capex. Working capital and replacement capex needs are of primary concern to management and boards.
6. EBITDA is a source for capital expenditures to finance growth. We segregate replacement capex from growth capex because they require different decision processes.  Investments for growth compete with the needs and desires of shareholders for current returns in the form of dividends or distributions. Shareholders are therefore keenly interested in decisions by management and boards to reinvest cash flows into capex for growth.
7. EBITDA is also the source for current dividends to shareholders or economic distributions after flow-through taxes for pass-through entities. EBITDA is also a source for current repurchases of shares from existing shareholders. Finally, if the owners allow it, EBITDA is the source of for the accumulation of cash or other excess assets on a company’s balance sheet.  These accumulations diminish owner returns and are not suggested. We mention them because of the frequency with which we see excess assets on balance sheets. See my earlier post about getting excess cash off of company balance sheets.

At the bottom of the figure, we see a portion labeled as “Operating Cash Flow (After Interest & Taxes).” Some analysts like to focus on this measure of cash flow, which is net of interest and taxes. That is natural since operating cash flow is the source of all the things that generate shareholder returns. Don’t forget, however, that operating cash flow began with EBITDA.

Four More Good Things About EBITDA

Good Thing #8 – The Starting Point for DCF

For good thing #8, let’s note that EBITDA is the beginning point of any discounted cash flow (DCF) analysis that is based on total capital, or enterprise cash flows.  This should be clear in the next figure.

The DCF analysis begins with EBITDA. Some forecasts actually begin with EBIT, but know that there was a DA before the EBIT, which is reflected in #1 in the figure above. The figure then walks down through four other measures of cash flow, reaching #5, or net cash flow to capital providers, which is the cash flow that is typically discounted to present in DCF valuation methods. These are the five measures of cash flow that were discussed in the previous post regarding 11 problems with EBITDA.

Good Thing #9 – Capitalizable Under the Income Approach

Goody #9 is that EBITDA is a capitalizable measure of gross cash flow under the income approach. Analysts can build multiples of EBITDA based on the Capital Asset Pricing Model directly. This is a relatively new realization (for me at least) and is based on an article I wrote for Business Valuation Review.

Good Thing #10 – Capitalizable Under the Market Approach

Good thing #10 is that EBITDA is a capitalizable measure of gross cash flow under the market approach. Using the guideline public company method, market multiples of (last 12-months) EBITDA and forward EBITDA are generally available for public companies. While it is often difficult to find guideline companies that are sufficiently comparable to subject private companies for direct valuation inferences, public market multiples provide excellent background market information for analysts and market participants.

This method works well for direct capitalization of EBITDA in single period models. It is also available to develop multiples for terminal value estimation in DCF valuation methods. This application would avoid what some perceive as a problem of mixing income and market when estimating terminal values with market multiples.

When reasonable guideline transactions information is available, EBITDA can also be capitalized under the market approach.

Market participants and analysts often focus on EBITDA because there is little or no market information available for the other measures of cash flow above like NOPAT, operating cash flow, or net cash flow to capital providers. Market multiples for EBIT are available for public companies, but their variability makes their use difficult. EBIT multiples are seldom available for guideline transactions.

Good Thing #11 – EBITDA is the Starting Point for All Good Things for Shareholders

The last “goody” of EBITDA has already been mentioned, but we repeat it here for emphasis and to reach the magic number of eleven to match the 11 problems of EBITDA noted in the previous post. The last goody is simply this:

EBITDA is the initial cash flow source of all good things that come to shareholders.

We show a final figure to illustrate the truth of this statement. EBITDA is represented by the first seven “goodies” noted above. Shareholder returns, which are comprised of capital appreciation and dividends/distributions and share repurchases, are shown at the bottom of the figure in the context of the relevant portions of EBITDA.

Conclusion

Despite the many so-called problems with EBTIDA, it is a measure of gross cash flow that deserves the attention of management, boards, shareholders, and business appraisers. EBITDA lends itself to thoughtful analysis for any company:

• What is the current level of EBITDA in terms of dollars and margin?
• How does the EBITDA margin compare with the recent history of a company?
• How does the margin compare with margins of other companies in the industry?
• How has EBITDA been growing (if it has), and how does that growth compare with a company’s market, its competitors and its potential?
• Does the company’s level of depreciation make sense based on its business model, existing stock of fixed assets, and outlook? (Or, does depreciation policy reveal anything of note to the analyst?)
• How does the forecasted EBITDA (in a DCF or projection) compare with a company’s history in terms of dollars and margins?
• From the referenced EBITDA article above, what is the relationship between a company’s EBIT and its EBITDA? Additionally, does that relationship make sense in light of comparisons with similar companies?
• Your questions next…

Other things being equal (as if they ever are), no one has ever suggested to me that a dollar more of EBITDA is not better than a dollar less.

There is much to be learned from analysis of EBITDA from the perspective of company management, boards, and analysts. I commend that objective analysis to you in the face of all the problems noted in the previous post.

New Books on the Way

• An Attorney’s Handbook for Buy-Sell Agreements (in production).  This book provides guidance based on 30-plus years of dealing with buy-sell agreements. Importantly, it provides for the first time ever, anywhere, draft template language for the valuation portions of buy-sell agreements that will work for clients or companies.  You will not want to miss this book!
• Business Valuation: An Integrated Theory Third Edition (with Travis Harms). The draft is due to the publisher (Wiley) shortly and will be available subject to their publication schedule. This book updates the Integrated Theory of Business Valuation and will include the Integrated Theory on an equity basis and on an enterprise (total capital) basis, as well. This book will be must reading for all business appraisers and anyone interested in business valuation.

E-mail me if you would like to be notified when these books become available:

mercerc@mercercapital.com

Be well until next time,

Chris