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EBITDA: use it ... or lose it?

INTRODUCTION

The use of Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA), became prevalent in the late 1980s when Leveraged Buyout (LBO) activity became widespread (Luciano, 2003). EBITDA was touted as a useful measure for determining the capacity of a targeted firm to service the debt incurred during the buyout, based on its normal operating cash flows. Many EBITDA pundits even used EBITDA as a modified Cash Flow from Operations or even a Free Cash Flow measure. EBITDA supporters claimed that it gave a better view of a firm's operations by stripping away the non-operational expenses that can obscure how the company is actually performing in its core operations. Interest, they believed, was a function of management's choice of financing arrangements; taxes can vary greatly depending on a number of complicated situations; depreciation and amortization are non-cash items and are based on accounting conventions and subjective decisions such as useful lives and salvage values. But EBITDA is a fundamental concept where you arrive at a performance measure free of the effects of specific financing and accounting decisions, and free of a specific tax situation. Damodaran (2006) suggests that the use of EBITDA leaves out information further down in the income statement such as income from minority holdings as well as the opportunity managers have to add value through skilled tax management. This suggests that EBITDA is free of a specific tax situation, but neglects the opportunity to add (decrease) value through skilled (poor) tax management practices.

Financial analysts use EBITDA as a measure of the financial health of a company, to calculate simple valuations of a firm based on EBITDA multiples, and often times as a measure of a company's operating cash flows. It is frequently utilized by companies with a large amount of fixed assets and thus extensive depreciation charges, which EBITDA adjusts for. The uses for EBITDA in business have grown since its inception, and along with it, so have the misuses. It is a popular measure based mainly on the simplicity of its calculation and the variety of its interpretations. While EBITDA has some highly useful applications, it should be used with caution, as the problems with EBITDA are plentiful and can lead to a number of erroneous conclusions. For instance, Grant and Parker (2002) show that there is no standardization for EBITDA calculations. Therefore, companies which report EBITDA may choose to include onetime cash charges and writedowns, or not.

As the acronym implies, to calculate EBITDA you start with Net Income and then add back the non-operating expenses of depreciation, amortization, interest, and taxes. Depreciation is the systematic allocation of the value of an asset over the useful life of the asset. It is classified as an expense for accounting and tax purposes, but is a non-cash item. Amortization is similar to depreciation in that it is a non-cash expense, mainly used to write-off intangible items such as Goodwill. Interest is a non-operating expense for the cost of borrowed funds. Interest is a cash expense and reduces the amount of taxes that the company pays. Taxes are paid on pre-tax income after deducting interest, depreciation and amortization.

CASH FLOW AND EBITDA

Positive cash flow is perhaps the single most important attribute of a successful business. Even a profitable business will not survive long if it does not have enough cash inflows to pay its creditors and other expenses. One method of evaluating a firm is in terms of the amount of Free Cash Flows. Free Cash Flows (FCF) are discretionary cash flows available to all investors (equity holders and debt holders) after the company has made all necessary expenditures to fixed assets and working capital in order to continue normal operations. Investors are interested in calculating FCF because a company with no expected future Free Cash Flows is likely to have very little or no value beyond a liquidation value. Damodaran (2006) shows that the terminal value of the firm can be calculated based on three approaches; the liquidation of the firm's assets, applying multiples as a proxy to capture the value of future cash flows, and assuming that current cash flows continue to grow at a constant rate indefinitely (perpetuity approach). With limited or no cash flow, liquidation value is a preferred method.

Many analysts use EBITDA as an approximation of cash flows, and some even call it Free Cash Flow, but this shortcut is not a substitution for the proper calculation of FCF. EBITDA estimates pretax, pre-interest, operating cash flows, but unlike FCF, it makes no allowance for necessary cash flows to working capital or capital expenditures. So while EBITDA might be a good indication of a company's ability to service its debt, it is missing some key cash flow considerations and is not a good overall indication of cash flows of the company. A true Free Cash Flow calculation should be done when needed, and when analyzing the operating cash flows, one should construct a Statement of Cash Flows, which has a section entitled "Cash Flows from Operations" where a true measure of cash flows from operations of a company can be seen (Eastman, 1997).

There are several key distinctions between the cash flows that an EBITDA calculation produces and the cash flows that are produced from the "Cash Flows from Operations" section of the Statement of Cash Flows and from a Free Cash Flow calculation. EBITDA starts with Net Income and adds back Interest Expense, Income Tax Expense, Depreciation, and Amortization. It is often used as a measure of operating cash flows. Proponents of EBITDA argue that Interest is added back because it is a function of financial leverage and not operations. Companies within the same industry will have vastly differing amounts of interest expense depending on the extent to which they use debt. Taxes are added back because they are influenced by various tax situations and account conventions, and are thus, not considered part of operations. Depreciation is added back because it is a non-cash item reliant upon on the amount of fixed assets that a firm has and can be different for various firms based on accounting convention and level of fixed assets; it has no real bearing on the operational strength of a company. Amortization is added back for similar reasons as depreciation, as it is an accounting convention dealing with the systematic expensing of intangibles (Luciano, 2003).

Cash Flows from Operations, as calculated on the Statement of Cash Flows, starts with Net Income and then adds back Depreciation and Amortization, just as EBITDA does. It then adjusts the Net Income figure for changes in non-cash Net Working Capital. One of the main differences between EBITDA cash flow and Cash Flow from Operations is that EBITDA ignores the cash flow effects of working capital. Working Capital is the difference between the current assets and current liabilities of a company. It is the cash needed for the company to do its "work" in the daily operations of a business and are essential cash outlays, especially for fast growing firms. Other differences are that EBITDA adds back Interest and Taxes. When we add back interest to earnings to calculate EBITDA, we are neglecting the fact that the interest must still be paid. While interest might not be considered a direct part of operations, debt is often essential for a company to operate. EBITDA also adds back taxes. Again while not necessarily part of operations, taxes are a result of operations and the resulting profits. The above differences are weaknesses in the EBITDA cash flow calculation in that working capital expenditures are essential for a company to operate and interest and taxes must be paid before virtually anything else (King, 2001). It is also essential to note that the Statement of Cash Flows is a GAAP (Generally Accepted Accounting Principle) statement while EBITDA is a non-GAAP measure. Grant and Parker (2002) find that some companies are using EBITDA and other pro-forma versions of earnings to present themselves as having more future earning power than is reasonable under GAAP. Grant and Parker conclude their study by identifying the importance of relating EBITDA to GAAP-derived cash flow measures.

A Free Cash Flow (FCF) calculation represents the cash flows that are available to all investors, shareholders and creditors, after all necessary cash outflows for the business are deducted. Free Cash Flow starts with Net Income and then adds back Interest and Taxes to arrive at Earnings before Interest and Taxes (EBIT). Taxes are then calculated based on the EBIT and then deducted from EBIT. Interest is not deducted because it is a cash flow that will be going to creditors (thus "free" for creditors to use). Depreciation and Amortization are then added back, just as in the previous two cash flow calculations. Free Cash Flows then adjust for changes in non-cash Net Working Capital, just like Cash Flow from Operations, as described above (Kousenidis, 2006).

Another difference between FCF and EBITDA and the primary difference between FCF and Cash Flows from Operations is that in a FCF calculation we deduct for Capital Expenditures. Capital Expenditures are necessary for any company, especially for a capital intensive company that must continually replace or repair their fixed assets, and can represent a significant reduction in cash flow. Thus, Capital Expenditures can be considered ongoing, operational cash flows needed for the long-term sustainability of any operation. Failure to invest in the needed capital assets or to provide adequate funds for ongoing working capital needs can have serious consequences for a company (Eastman, 1997).

EBITDA is not a measure of discretionary Free Cash Flow, nor is it a truly accurate measure of operational cash flows. EBITDA is one way to measure operating cash flow, but does not give a full picture of the cash flows necessary to continue operations. When the above differences between the various cash flow metrics are understood, each has its place in financial analysis. The problem arises when the measures are confused, as is often the case. Many analysts who use EBITDA, however, fail to consider this fact. Fridson (1998) states that "EBITDA has been erroneously equated with cash flow; cash flow is useful but not an entirely sufficient tool; and focusing on a single variable sets credit analysis back by 30 years."

DEBT SERVICE ANALYSIS AND EBITDA

Another popular use of EBITDA is in aiding in the determination of the ability of a company to adequately service its debt. A useful measure of this is the Times Interest Earned/Interest Coverage ratio. The Times Interest Earned ratio (TIE) gives us an idea of whether operating income is sufficient to cover interest payments. It is basically the number of times that available cash can be used to "cover" or pay the minimum debt obligations or interest payments. One way to calculate the TIE ratio is to simply take EBITDA and divide it by total interest charges. A high TIE ratio indicates that if a firm were to experience a significant decline or lack of earnings, it would be able to cover interest expenses longer. Thus, it would take longer for a firm to go into default. Foss (1995) finds that the EBITDA interest coverage ratio is highly correlated to the market's relative risk levels as a function of the credit rating. Foss suggests that the EBITDA interest coverage ratio incorporates both business and financial risk and investors can utilize this ratio to discern important financial trends in the corporate bond market.

The use of EBITDA became popular in the latter part of the 1980s when Leveraged Buyouts (LBO) became widespread (Luciano, 2003). In an LBO, one firm is acquired by another firm where a significant portion of the purchase is financed through leverage, or debt. The assets and earnings of the acquired company are used as collateral for the borrowing. If other debt is used, such as issuing bonds, these bonds are often high risk, non-investment grade junk bonds. EBITDA was emphasized as a metric for determining the capacity for the firm to make the necessary debt obligations based on its normal operating cash flows. EBITDA, it was argued, was a better measure of debt service capabilities than the other traditional interest coverage ratios, such as EBIT/Interest. This thought process might be sufficient in the short run, but the use of EBITDA as a proxy for cash flow neglects to take into consideration long run effects, such as cash needed to fund capital expenditures, working capital, and other needed cash outflows. These items are accounted for below EBITDA in free cash flow analysis (Damodaran, 2006). This factor has led many to question the use of EBITDA in their analysis. For instance, Warren Buffett has stated, "Does management think the tooth fairy pays for capital expenditures?" (MacDonald, 2003). His view is that a company could spend countless amounts of money on capital expenditures and it would not appear on the company's EBITDA reports.

BUSINESS VALUATION AND EBITDA

EBITDA can also be used in simple business valuations by utilizing what is known as the EBITDA multiple or Value/EBITDA multiple. The traditional calculation of an EBITDA multiple is:

Value/EBITDA = [Market Value of Equity + Market Value of Debt]/EBITDA

In light of changes in the business environment and the need for more sophisticated measures, there is an alternate measure called the No-Cash Value/EBITDA method, the formula for which is:

Value/EBITDA = [Market Value of Equity + Market Value of Debt - Cash]/EBITDA--Interest Income

The EBITDA multiple resulting from these formulas offers a simple estimate of the firm's value in terms of EBITDA. You can then compare firms of differing sizes based on their relative EBITDA multiples or to some average multiple for the industry.

There are several reasons why analysts like to use EBITDA multiples. First of all, it is quick and easy to calculate. While this is generally not a good reason for using a financial analysis tool, in certain situations a "quick and dirty" analysis is all that is needed. Secondly, a value for a firm can be estimated even for firms with negative net earnings, as EBITDA is usually positive. This is common practice for start-up companies that are generally operating at a loss. King (2001) notes that early Internet companies were often evaluated based on their EBITDA, as they often took on large amounts of debt, had high amounts of goodwill recorded, and made various acquisitions for stock. Under GAAP measures these companies showed large losses, but when you add back interest, pay no taxes on losses, and add back depreciation and amortization, you get a positive EBITDA. An EBITDA multiple may also be more relevant than a Price Earnings ratio for firms that have a high amount of capital tied up in long-term capital investments. Such firms tend to be ones that need a large degree of infrastructure to operate. These firms generally have large depreciation write-offs, and using EBITDA as a profitability measure negates the effects of these non-cash items.

Over the years, the use of EBITDA multiples has garnered wide support. Finnerty (2004) notes that EBITDA has emerged to be the most accepted performance measure on which to base valuation multiples. In a 2008 study, Anderson (2008) finds that EBITDA provides the greatest Market Value Added (MVA) relationship in firm valuation. Finally, EBITDA multiples have been shown to generally produce more accurate valuation estimates than EBIT multiples (Lie, 2002). But the general consensus is that EBITDA provides a good starting point, not an ultimate valuation.

When analysts value a firm based on a price to earnings multiple, they will often adjust for the effects of nonrecurring items or accounting conservatism (Demirakos, Strong, and Walker, 2004). This is very often the case when nonrecurring or accounting effects result is negative, very low, or very high transitory earnings. It is standard practice among the analyst community to normalize earnings to a more sustainable level. One technique to normalize earnings involves the following formula:

[V.sub.t] = [([EBITDA.sub.t+[tau]])/[(1+WACC).sup.[tau]]] x [(EV/EBITDA).sub.[tau]]

where: [V.sub.t] = fundamental value of the firm at date t

[EBITDA.sub.t+[tau]] = EBITDA in period t + [tau]

WACC = the firm's weighted average cost of capital

[(EV/EBITDA).sub.t] = enterprise value to EBITDA multiple at time t

Financial analysts normalize financials by projecting forward to the period when the firm is expected to reach a normal operating cycle. This future period, shown as t + [tau] in the equation above, is spanned by discounting the resulting normal EBITDA value to the present using the firms discount rate and then multiplying by the industry EV/EBITDA multiple attained from a comparable list of firms.

Even analysts who employ rather sophisticated valuation techniques will often utilize EV/EBITDA when estimating the terminal value of a firm or checking their results of their complex model for plausibility (Bhojraj & Lee, 2002). Of analysts surveyed on their preferred methodology for valuation of a firm, 67% indicated that Multiples was their predominant choice versus 16% indicating the use of Discounted Cash Flow, and 10% using Residual Income Valuation (Demirakos, Strong, & Walker, 2004). Damoradan (2006) surveys 550 sell-side equity research papers and finds that the use of comparables using a multiple, such as EV/EBITDA, outnumbers fundamental equity valuation models (DCF and RIV) by a proportion of almost ten to one.

EBITDA WARNINGS

Although this EBITDA methodology appears simple, analysts must be aware of its limitations. It is important to realize that EBITDA calculations do not conform to Generally Accepted Accounting Principles (GAAP) and that EBITDA multiples are not particularly useful out of context. Unfortunately, analysts often forget that EBITDA is an adjusted figure, and will accept it as the actual cash flow of a company. If an analyst needs the actual cashflows of a publicly traded company, the Statement of Cashflows is a much more useful source. For nonpublic companies, EBITDA might be a good starting point (Pratt, Reilly, & Schweis, 1998). It is possible to use EBITDA as a measure of earnings, but again, this line of thought should be considered only in the context of what EBITDA truly measures, and what it leaves out. Cornell and Landsman (2003) provide some context on earnings quality by showing that the information conveyed by the differing approaches for earnings (GAAP, EBITDA, operating income, and pro forma earnings) are similar. The authors caution, however, that the definition of non-GAAP earnings measures is far from unambiguous and therefore creates issues when comparing different companies. Analysts must also be aware that EBITDA can be positive even when true earnings are negative. Although in certain situations this might not be a problem, no firm can sustain itself with consistent negative earnings. For that reason, using EBITDA as a valuation tool should only be used if negative earnings are not expected to continue in the future. Many dot-com companies were trapped in this delusion of valuation.

In order to get a more accurate interpretation of the value of a firm using the EBITDA multiple, an analyst should be aware that there are many ways to manipulate the numbers. Calabrese (2003) points out several factors that need to be considered when EBITDA is used as a basis for valuation, cash flows, or other financial analysis. A business will often try to manipulate the EBITDA figure to show itself in the most positive manner possible, often using creative or aggressive accounting techniques. Add-backs to EBITDA for items that the business portrays as one-time extraordinary occurrences need to be scrutinized carefully to make sure they are not actually common, recurring events.

Inventory write-downs must also be analyzed. Another possible problem is where manufactures report a sale of a product because it is sitting on the shelves of a retailer. However, many of these items are returned to the manufacturer, and must be removed from earnings (King, 2001). Percentage-of-completion accounting is another example where EBITDA fails to portray accurate cash flows. When firms use percentage-of-completion accounting, the reported revenues are based on the incurrence of costs. As a result, the timing of revenues might not have direct correlation to the timing of invoicing or delivery. And more importantly, it might not have a direct relationship to the actual cash receipt (Calabrese, 2003).

CONCLUSION

Financial analysts use EBITDA in a number of applications such as measuring the financial performance of a company, calculating simple valuations of a firm, and as a measure of a firm's cash flows. Proponents of using EBITDA believe that it gives a better view of a firm's core operations by peeling away the non-operational expenses that can obscure how the company is actually performing. While EBITDA has some highly useful applications, it should be used with caution, as the problems with EBITDA are numerous and can lead to a number of hasty conclusions.

Many analysts use EBITDA as an approximation of cash flows, and sometimes even as a Free Cash Flow calculation, but EBITDA is not a substitution for the proper calculation of FCF, as it makes no allowance for cash flows to working capital or capital expenditures needed for continuing operations (Eastman, 1997; Fridson, 1998). Nor is it an accurate measure of operational cash flows. EBITDA is one way to measure operating cash flow, but does not give a full picture of the cash flows, such as working capital, necessary for a company to operate. But when these differences between the various cash flows are understood, each has its place in financial analysis.

Another popular use of EBITDA is in aiding in the determination of the ability of a company to adequately service its debt and EBITDA is often thought to be a better measure of debt service capabilities than the other traditional interest coverage ratios. EBITDA Interest coverage might be sufficient in the short run, but EBITDA neglects to take into consideration long run effects, such as cash needed to fund capital expenditures and working capital.

EBITDA can also be used in simple business valuations by utilizing the EBITDA multiple and then comparing firms based on their relative EBITDA multiples or to some average multiple for the industry. EBITDA multiples have gained support and EBITDA has come to be a widely accept measure on which to base valuation multiples. But the general consensus is that EBITDA provides a good starting point, not an ultimate valuation.

REFERENCES

Anderson, A., Bey, R., & Weaver, S. (2008). Measures of Income and Firm Valuation. Corporate Finance Review, 12, 10-15.

Bhojraj, S., Lee, C. (2002). Who Is My Peer? A Valuation Based Approach to the Selection of Comparable Firms. Journal of Accounting Research, 40, 407-439.

Calabrese, J., & Rafferty, B. (2003). EBITDA: What Your Borrower is Measuring and How it Affects Cash. Commercial Lending Review, 18, 41-44.

Cornell, B., & Landsman, W. (2003). Accounting Valuation: Is Earnings Quality an Issue? Financial Analyst Journal, 6, 20-28.

Damodaran, A. (2006). Damodaran on Valuation, 2nd edition. Wiley, Hoboken, NJ.

Demirakos, E., Strong, N., & Walker, M. (2004). What Valuation Models Do Analysts Use? Accounting Horizons, 4, 221-240.

Eastman, K. (1997). EBITDA: An Overrated Tool for Cash Flow Analysis. Commercial Lending Review, 12, 64-69.

Finnerty, J., & Emery, D. (2004). The Value of Corporate Control and the Comparable Company Method of Valuation. Financial Management, 33, 91-100.

Foss, G. (1995). Quantifying Risk in the Corporate Bond Market. Financial Analyst Journal, 2, 29-34.

Fridson, M. (1998). EBITDA is Not King. Journal of Financial Statement Analysis, 3, 59-62.

Grant, J. & Parker, L. (2002). EBITDA!, Research in Accounting Regulation, 15, 205-212.

King, A. (2001). Warning: Use of EBITDA May be Dangerous to Your Career. Strategic Finance, 83, 35-37.

Kousenidis, Dimitrios, V. (2006). A Free Cash Flow Version of the Cash Flow Statement. Managerial Finance, 32, 645-653.

Lie, E., & Lie, H. (2002). Multiples Used to Estimate Corporate Value. Financial Analysts Journal, 58, 44-54.

Luciano, R. (2003). EBITDA as an Indicator of Earnings Quality. Journal of the Securities Institute of Australia, 1, 29-34.

MacDonald, E. (2003). The EBITDA Folly. Forbes, March 17, 2003, 165.

Pratt, S., Reilly, R., and Schweis, R. (1998). Valuing Small Businesses and Private Practices, McGraw-Hill Publishing, 3rd edition.

Christopher M. Brockman

University of Tennessee at Chattanooga

Judson W. Russell

University of North Carolina--Charlotte

Christopher M. Brockman earned his Ph.D. at the University of Alabama in 2000. He is currently an Associate Professor of Finance at the University of Tennessee at Chattanooga and holds the UBS Professorship in Portfolio Management.

Judson W. Russell earned his Ph.D. at the University of Alabama in 1998. He is currently a Clinical Associate Professor of Finance in the Belk College of Business at the University of North Carolina--Charlotte.
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Title Annotation:Earnings before Interest, Taxes, Depreciation, and Amortization
Author:Brockman, Christopher M.; Russell, Judson W.
Publication:International Journal of Business, Accounting and Finance (IJBAF)
Article Type:Report
Geographic Code:1USA
Date:Sep 22, 2012
Words:4087
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