EBITDA – 1 Best complete read

EBITDA – Earnings before interest taxes depreciation and amortisation

– is a measure of a company’s overall financial performance and is used as an alternative to simple earnings or net income in some circumstances. Earnings before interest, taxes, depreciation and amortisation, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.

This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions.EBITDA

Simply put, Earnings before interest, taxes, depreciation and amortisation is a measure of profitability. While there is no legal requirement for companies to disclose their EBITDA (here also written as EBIT-DA), according to the U.S. generally accepted accounting principles (US GAAP) or International Financial Reporting Standards (IFRS), it can be worked out and reported using information found in a company’s financial statements.

The earnings, tax, and interest figures are found on the income statement, while the depreciation and amortisation figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT) and then add back depreciation and amortisation.

https://www.merriam-webster.com/dictionary/EBITDA

Origins of EBITDA

EBITDA first came into common use with leveraged buyouts in the 1980s, when it was used to indicate the ability of a company to service debt. As time passed, it became popular in industries with expensive assets that had to be written down over long periods of time. Earnings before interest, taxes, depreciation and amortisation is now commonly quoted by many companies, especially in the tech sector – even when it isn’t warranted.

A common misconception is that Earnings before interest, taxes, depreciation and amortisation represents cash earnings. Earnings before interest, taxes, depreciation and amortisation is a good metric to evaluate profitability, but not cash flow. Earnings before interest, taxes, depreciation and amortisation also leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant.

Consequently, Earnings before interest, taxes, depreciation and amortisation is often used as an accounting gimmick to EBITDAdress up a company’s earnings. When using this metric, it’s key that investors also focus on other performance measures to make sure the company is not trying to hide something with Earnings before interest, taxes, depreciation and amortisation.

The EBITDA Multiple, representing ratios used when the entity has determined that market participants would use such multiples when pricing the investments, are also used as unobservable inputs in IFRS 13 Fair value measurement (market comparable companies). Such EBITDA multiples may range between 10 – 13 times EBITDA (Healthcare industry) and 6.5 – 12 times EBITDA (Energy industry) for continued operations and 3 – 5 times terminal EBITDA for terminal values.

Selecting comparable company valuation multiples

An investor is measuring the fair value of its non-controlling equity interest in Entity H, a private company. Entity H is a car manufacturer. The investor has selected five comparable public company peers: Entities B1, B2, B3, B4 and B5. These entities have the same risk, growth and cash flow-generating potential profiles as Entity H. They also operate in the same market (luxury passenger cars) and are at a similar stage of development as Entity H.

The investor concludes that EBIT or EBITDA are both relevant performance measures for Entity H. For this reason, and also to remove any distortion in the valuation multiples that the differences in capital structure between Entity H and its comparable public company peers might cause, the investor has decided to consider both EV/EBIT and EV/EBITDA multiples as potential relevant valuation multiples to measure the fair value of Entity H.Entity H and its comparable public company peers have similar asset bases.

When comparing Entity H with Entities B1–B5, the investor observes that Entities B1 and B2 have depreciation policies (ie useful life estimates for the depreciation of their tangible assets) that are similar to that of Entity H.

However, Entities B3–B5 have a very different depreciation policy that uses a much longer useful life for the depreciation of their tangible assets than Entity H does, resulting in a lower depreciation expense. Entity B4’s depreciation policy is in between Entity H’s and Entities B3 and B5.

The EV/EBIT and EV/EBITDA multiples are as follows:

EBITDA

The investor observes that the range of the EV/EBITDA multiples is narrower (5.9x–6.9x) than the range of EV/EBIT multiples (6.3x–10.0x).

While the average and median EV/EBIT multiples are very close, the differences in the depreciation policy between Entity H and Entities B3–B5 does not make them comparable at an EBIT level and, consequently, neither the average nor the median EV/EBIT multiples are relevant in valuing Entity H.

The average and median EV/EBITDA multiples are also very close. In this example, the investor selects the EV/EBITDA multiple because it considers that all five entities are comparable to Entity H at EBITDA level. The differences in depreciation policy do not affect the EV/EBITDA multiple, because the earnings used in this multiple have not been reduced by any depreciation expenses. Consequently, the investor concludes that the EV/EBITDA multiple is the most relevant multiple to measure the fair value of Entity H.

The multiples were prepared using information from Entities B1–B5’s financial statements at the end of the reporting period, which coincides with the measurement date. The investor confirmed that the accounting policies of the remaining underlying assets of the comparable public company peers and of Entity H were the same. No additional adjustments to the valuation multiples were deemed to be necessary.

In determining where within the range to select the multiple, the investor observes that the average and median multiples are very close. The investor selects an EV/EBITDA valuation multiple of 6.7x because it believes that Entity H has characteristics (for example, risk, growth and cash flow-generating potential profiles) that are similar to the comparable public company peers at the upper end of the range of valuation multiples.

Investment industry / M&A

For traders, analysts, portfolio managers, and others, EBITDA is an indicator of whether companies are properly valued. It is also a gauge for lenders to know if companies will be able to pay their future debt obligations. However, while EBITDA provides a valuable snapshot of a point in time in a firm’s cycle, it does not necessarily provide a complete picture of a business’ true value or performance.

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So,

EV / EBITDA = (Market value equity +/+ Market value of debt -/- Market value surplus cash) / EBITDA

EBITDA can be used as a rough tool for comparison for businesses like real estate or land companies where large, ongoing needs for capital expenditures are minimal. However, as with all ratios EBITDA can be misused as an analytical tool.

EBIT – an alternative

When comparing firms with different level of borrowing, EBITDA is best because it does not deduct interest. It is true EBITDA increases comparability of companies with markedly different financial gearing, but it is also true that the less distortionary EBIT (earnings before interest and tax deduction) can do the same without the exclusion of depreciation or amortization.

EBITDA is close to cash flow

Yes and No.

Just like cash flow from operating activities EBITDA is less suspectible to accounting estimates such as estimation of depreciation, amortization and other non-cash items that are vulnerable to judgment error, but cash flow from operating activities is still suspectible to one-time effects of collecting revenue from customers (trade debtors) fast(er) and paying purchases of goods, materials and general expenses to trade creditors slow(er) by management.

EBITDA shows large positive numbers

Some cynics have renamed it, Earnings Before I tricked the dumb auditor.

If you manage an Internet company that makes a $ 100 million loss and the future looks pretty dim unless you can persuade investors and bankers to continue their support, perhaps you would want to add back all the interest ($50m), depreciating on assets that are wearing out or becoming obsolete (say $40), and the declining value of intangible assets, such as software licenses and goodwill amortization of $65m, so that you could show a healthy positive number on EBITDA or $55m.

The use of EBITDA by company directors can make political spin doctors look like amateurs by comparison. EBITDA is not covered by any accounting standards so companies are entitled to use a variety of methods—whatever shows the company in the best light.

So,

A conclusion

The use of EBITDA and related EBIT ratios as a single measure of cash flow without consideration or other factors can be misleading.

EBITDA is probably best assessed by breaking down its components into EBIT, Depreciation and Amortization.EBITDA

Generally speaking, the greater the percentage of EBIT in EBITDA, the stronger the underlying cash flow.

EBITDA is relevant to determining cash flow in its extremis. EBITDA remains a legitimate tool for analyzing low-rated credit at the bottom of the cycle. Its use is less appropriate, however, for higher-rated and investment grade credits particularly mid-way through or at the top of the cycle.

EBITDA is a better measurement for companies whose assets have longer lives—it is not a good tool for companies whose assets have shorter lives or for companies in industries undergoing a lot of technological change.

EBITDA can easily be manipulated through aggressive accounting policies relating to revenue and expense recognition, asset write-downs and concomitant adjustments to depreciation schedules, excessive adjustments in deriving ―adjusted pro-forma EBITDA,‖ and by the timing of certain ―ordinary course‖ asset sales.

and some more……

Adjusted EBITDA

Getting a better valuation is one of the most important considerations when selling a business. Using an adjusted EBITDA calculation can help enhance your company’s attractiveness by providing the buyer an accurate depiction of future cash flow.

The adjusted EBITDA calculation takes into account certain items that have no bearing on a firm’s actual operational costs including non-recurring or one-time expenses.

Due to the way private companies account for these items, the use of adjusted EBITDA is more typical of private deals.

“A private company’s expense structure may not reflect market compensation rates, and often are not reported in accordance with generally accepted accounting principles (GAAP) standards,” says a market analyst. “In publicly traded companies, which are subject to GAAP accounting, such anomalies aren’t as prevalent.”

Aside from distinctions in size, the items that are included in the adjusted EBITDA calculation vary for every company depending on its payment structure and expenses. Using the adjusted EBITDA calculation, companies can take out an extraordinary item including one-time litigation expenses or not factor that into a company’s ongoing expenses.

There are no set rules as to which of these items need to be removed or added back into the adjusted EBITDA calculation. Thus it is important for sellers to work closely with their advisors to determine what goes into the computation to get the best price and valuation for their companies in an M&A deal.

“When it comes to adjusted EBITDA, this is often a matter of negotiation as to which items can be added back to the operating expenses of the company and which items are discretionary, extraordinary or non-recurring,” says a transaction analyst.

“A good investment banker will construct a defensible rationale for add-backs and negotiate vigorously around these items; however, the best defense is to it’s best to run as clean an operation as possible leading up to a sale.”

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Keeping a clean operation is a good rule of thumb for CEOs to remember — this means the less discretionary add-backs to EBITDA, the better it is for acquirer confidence.

Use EBITDA in a complete context

Experts agree that EBITDA has limitations and should be taken in the context of other factors in the transaction. Buyers seriously interested in your company will also conduct in-depth due diligence processes to examine your company’s financials over a longer period of time.

This is essential for buyers to get a proper assessment of a business’s worth.

“EBITDA is only the starting point and due diligence should result in the discovery of whatever operational issues there are in the financial reporting and EBITDA,” says an analyst.

The due diligence can either happen before or after the letter of intent (LOI). There is no set practice for when due diligence is conducted — many buyers already conduct rigorous due diligence before they submit an LOI or have a more intensive process after the LOI.

EBITDA is a reliable number that the industry cannot ignore. However, investors have to use a variety of measurements when buying a company — including, as demonstrated above, testing for the quality of earnings as part of their due diligence.

“While EBITDA is a good measure especially when comparing investments, it is not a catch-all metric that can completely capture a company’s worth,” says an analyst. “Many owners have become fixated on multiples of earnings or multiples of EBITDA. That can leave significant value on the table.” This is especially true, he says, as intangibles are increasingly becoming a larger part of a company’s overall value.

Intangibles — non-physical assets like intellectual property (i.e. patents and trademarks) and brand recognition — “are receiving more and greater importance in deals and, ultimately, multiples,” the analyst says. Building a company’s value through intangibles can significantly increase its value over time.

The case of intangibles is clearly a situation where EBITDA plays a smaller part in valuing a company.  Especially at early stages of operations of such companies, EBITDA might not provide a sound basis for determining the real value of the enterprise.

The warning here is — “don’t just stop at looking at EBITDA as a proxy for value. Great bankers can help owners monetize the intangibles as well,” the analyst says. “As with many things, the total value of a company cannot be reduced to just one number.” He encourages acquirers to factor in the following as part of their analysis:

  • Growth rates
  • Size
  • Intangibles
  • Quality of earnings
  • Intellectual property
  • Barriers to entry
  • Recurring revenue
  • Customer concentration issues

These are “on par or even more important than EBITDA,” the analyst says. For a business owner considering sale, it’s important to focus on and account for each of these factors of interest.

Other metrics for measuring financial performance

Most industries use a combination of adjusted EBITDA and free cash flow to measure how companies are faring. However, although EBITDA has become a standard metric for financial performance, certain types of companies or industries have relied on other metrics for various reasons.

Other metrics that measure financial performance:

  • Variance of a company’s capex cycles (e.g. manufacturing firms)
  • Multiple of revenue (e.g., technology companies)
  • Multiple based on the return on a company’s assets/book value (e.g., banks and financial institutions)
  • Network effect (e.g., services and technology businesses)
  • EBITDAR (e.g., restaurants and casinos), see below

There are some types of businesses, for instance, where EBITDA is not an indicator of a firm’s profitability. Profits that cannot be measured through EBITDA can be explained by a number of factors including a variance in company cycles.

Consider manufacturing firms that require ongoing and significant capex. Since EBITDA does not take into account a company’s capex, the calculation might not reflect how the frequency and severity of these expenses have hurt a company’s profit.

Buyers have taken these discrepancies in company cycles into account when calculating the price they want to pay for targets in these industries. So even if “there may be EBIT-DA issues that surface during due diligence, an offered and accepted purchase price might still be expressed in some multiple of EBIT-DA,” says managing director at a Valuation expert. “In such cases, the EBITDA might just be a catch-all after buyers determine that they want to pay X price for a deal.”

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Aside from capex cycles, in some privately held situations, buyers do not use EBIT-DA, but develop a price as a multiple of a firm’s revenue.

For technology and services companies, for instance, a multiple of revenue is used Most industries use a combination of adjusted EBIT-DA and free cash flow to measure how companies are faring. However, although EBIT-DA has become a standard metric for financial performance, certain types of companies or industries have relied on other metrics for various reasons.

Other metrics that measure financial performance:

  • Variance of a company’s capex cycles (e.g. manufacturing firms)
  • Multiple of revenue (e.g., technology companies)
  • Multiple based on the return on a company’s assets/book value (e.g., banks and financial institutions)
  • Network effect (e.g., services and technology businesses)
  • EBITDAR (e.g., restaurants and casinos)

There are some types of businesses, for instance, where EBIT-DA is not an indicator of a firm’s profitability. Profits that cannot be measured through EBIT-DA can be explained by a number of factors including a variance in company cycles.

Consider manufacturing firms that require ongoing and significant capex. Since EBIT-DA does not take into account a company’s capex, the calculation might not reflect how the frequency and severity of these expenses have hurt a  company’s profit.

Buyers have taken these discrepancies in company cycles into account when calculating the price they want to pay for targets in these industries. So even if “there may be EBIT-DA issues that surface during due diligence, an offered and accepted purchase price might still be expressed in some multiple of EBIT-DA,” says a managing director at a Valuation expert. “In such cases, the EBIT-DA might just be a catch-all after buyers determine that they want to pay X price for a deal.”

Aside from capex cycles, in some privately held situations, buyers do not use EBIT-DA, but develop a price as a multiple of a firm’s revenue.

For technology and services companies, for instance, a multiple of revenue is used because of limitations in their cash flow and EBIT-DA. “While many technology companies have high revenue and other metric growth rates, they are generally reinvesting to fund their growth and, therefore, are not yet cash flow positive or have limited EBIT-DA,” says a chairman of an investment bank.

Buyers are concerned about revenue streams. Technology and services companies in particular measure performance through their growing customer lists. For these firms, the number of subscribers is a draw for investors — even if they cannot show strong EBIT-DA.

“This is what is known as the network effect,” a professor of business administration at a school of business, says. “Once a firm gets to a critical number, it does not have to wait to profit before investments can start to come in. In this instance, investors do not need to wait for EBIT-DA, but invest in these companies a little bit earlier.”

For banks and other financial institutions, they typically use a multiple based on the return on a company’s assets or book value. In this case, the financial industry is generally looking at the return on equity.

A different measurement known as EBIT-DAR is used for organizations with high rent costs such as restaurants and casinos. EBITDAR expands on EBIT-DA by including “R” for rents to provide a more accurate picture of a firm’s financial performance.

EBITDA

EBITDA

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