Perhaps someone here can refresh my mind on why people (often private equity types) center on EBITDA multiples for computing enterprise value, as opposed to EBIT or FCFF multiples? I understand EBITDA as a quick-and-dirty estimate of cash flow from operations (CFO), and is a reasonable approximation if you think the work involved in computing true CFO doesn’t give you much additional information. What confuses me is why one would dismiss depreciation and amortization from a valuation multiple? For a company with few fixed assets, maybe this is defensible, but doesn’t PPE have to be replaced eventually? Why would you use a multiple that ignores this? Is it just convention? Do we assume that every business in the same industry has the same PPE age and structure and therefore are comparable? Would love to hear from people who know more about this.
I work in business development, so we often use p&l multiples because small business owners often don’t have balance sheets. We’re actually lucky if they have a coherent p&l, opposed to just random revenue reports generated from their janky customer databases. The private equiteer discusses this topic. It’s not a perfect answer, but it’s a start http://www.theprivateequiteer.com/an-apples-vs-apples-comparison-of-earnings-for-valuation/
I think most people look at EBITDA then look at depreciation separately. As you said, EBITDA gives you a quick look at cash flows, then from there you can compare different companies’ depreciation on a stand-alone basis. So if two firms have similar EBITDA multiples, but one has significantly more depreciation I might find that attractive, but then I’d look at their capital structure and so on. EBITDA is just a little cleaner than straight-up earnings and allows you to break down the individual components further. That’s all.
This is an excellent question. The idea is that you need to compare on a apples to apples basis. Also, remember that depreciation and amortization are non-cash expenses. Say you are comparing the valuation of a manufacturing company (heavy depreciation) to a consulting company (low depreciation.) It would be more appropriate to perform valuations on an EBITDA basis if you wanted to compare. see this as well: Why do analysts focus on EBITDA? The Good EBITDA can be used to analyze the profitability between companies and industries. Because it eliminates the effects of financing and accounting decisions, EBITDA can provide a relatively good “apples-to-apples” comparison. For example, EBITDA as a percent of sales (the higher the ratio, the higher the profitability) can be used to find companies that are the most efficient operators in an industry. The ratio can also be used to evaluate different industry trends over time. Because it removes the impact of financing large capital investments and depreciation from the analysis, EBITDA can be used to compare the profitability trends of, say, “heavy” industries (like automobile manufacturers) to high-tech companies. The accounting rules known as FAS 142, which eliminate the amortization of goodwill, bring operating income closer to EBITDA, but EBITDA continues to be a better measure of core operating profitability. The Bad EBITDA is a good metric to evaluate profitability but not cash flow. Unfortunately, however, EBITDA is often used as a measure of cash flow, which is a very dangerous and misleading thing to do because there is a significant difference between the two. Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use/provide cash (such as changes in receivables, payables and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether or not a company is losing money because it cannot sell its products! The Ugly It gets ugly when EBITDA is used as a key measure for making investment decisions. Because it is easier to calculate, EBITDA is often used as a headline metric in discussing a company’s results. This, however, could, as discussed above, misrepresent the true investment potential of a company because it does not accurately reflect a firm’s ability to generate cash. Conclusion EBITDA is a good measure to use to evaluate the core profit trends, but cash is king. EBITDA can be used to evaluate the profit potential between companies and industries because it eliminates some of the extraneous factors and allows a more “apples-to-apples” comparison. But EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Cash is king because it shows “true” profitability and a company’s ability to continue operations. The experience of the W.T. Grant Company provides a good illustration of the importance of cash generation over EBITDA. Grant was a general retailer in the time before malls and was a blue chip stock of its day; however, management made several mistakes. Inventory levels increased, and the company needed to borrow heavily to keep its doors open. Because of the heavy debt load, Grant eventually went out of business, but the top analysts of the day that focused only on EBITDA missed the negative cash flows. Many of the missed calls of the end of the dotcom era mirror the recommendations Wall Street once made for Grant. History does repeat itself.
Great stuff. I’m pulling out the following ideas: 1) Use EBITDA to analyze underlying profitability. 2) EBITDA is a decent proxy for CFO as long as working capital does not change substantially over time, and can lead you astray if it does. 3) Use EBITDA if you want to control for the effects of different depreciation methods (so you can apply your own standard D&A methods when comparing companies). We’re still not at an answer to why PE folks seem to use EBITDA multiples as comparables. DoubleDip’s post suggests that it’s a big mistake to think of EBITDA in a cash flow measure in this way. I would think that EBIT multiples would be better than EBITDA multiples for PE work (though EBIT would have the same issues with working capital as EBITDA).
^ Simple convention perhaps? If everyone else uses it, then you have to look at it too.
dspapo Wrote: ------------------------------------------------------- > I work in business development, so we often use > p&l multiples because small business owners often > don’t have balance sheets. We’re actually lucky > if they have a coherent p&l, opposed to just > random revenue reports generated from their janky > customer databases. > > The private equiteer discusses this topic. It’s > not a perfect answer, but it’s a start > > http://www.theprivateequiteer.com/an-apples-vs-app > les-comparison-of-earnings-for-valuation/ Just read dspapo’s link… good stuff… it confirmed that my thinking wasn’t crazy and provided some useful extra insights. From this, it seems that taking EBITDA and then adjusting using one’s own forward-looking CapEx (and changes in working capital) is probably the best one can do, though they author recommends EBIT - DAC, whatever DAC is.
The basic idea of using an earnings based approach to valuation is that you are trying to obtain a measure of cash flow to value the company. D&A are non-cash expenses, thus EBITDA is often used as a proxy for cash flow. EBIT is also used as a proxy for cash flow if a company has negligible D&A. FCF is obviously the best way to calculate the cash a firm is able to generate as it takes into consideration WC items, and FCInv (which EBITDA and EBIT ignores). PE folks and M&A bankers use EBITDA because it is quicker and easier than going through the FCF process, especially when you know that WC items have not changed that much and FCInv is small. Academics and financial theorists hate EBITDA as a measure for cash flow because of the aforementioned holes in its calculation as a measure of cash flow. Bankers love it because it is quick and easy and sounds good.
I think the PE guys want to see a rough approximation of cash flow because they’ve levered up the company and need to make sure the company can service the debt. So they are less concerned with noncash expenses.
DD captured the idea quite well. its most widely used to eliminate accounting decisions when comparing two or more companies in the same industry. i would also note that it is useful in industries where depreciation is longer-term and little upkeep is needed over time, i.e. REIT and Utilities sectors. as for PE, I don’t work with the area but i work in a PE hotbed and my suggestion is that small firms tend to only have short-life assets (i.e. computers, cars, etc) which depreciate on paper faster than their useful life, but more importantly, especially where i live, is the amortization of intellectual property. assumptions have to be made about the life of a patent or piece of software and by removing the amortization of intellectual property, you eliminate accounting assumptions, which can vary widely as start-ups generally have limited financial/accounting help. by eliminating this charge which varies greatly from company to company, you can forecast earnings/revenue growth rates much easier. you also eliminate a charge that requires no reinvestment (this is how start-ups are different from large manufacturing companies that use depreciating equipment). you also amplify the earnings/cash flow figures and make it easier to identify growth in these figures.
Interesting thread here. I’m reading Klarman’s Margin of Safety and he spends a decent part of a chapter dissing EBITDA and saying you should use after-tax profits instead. Edit: Oh and according to Klarman the reason PE people use it is b/c it can be used to justify the high valuations of companies that require significant capital upkeep.
Are you reading an actual copy or the online version? Just curious.
LOL. If I had an actual copy, i’d sell it to someone real cheap. $800 bucks. Dude needs to have someone publish an updated version post haste.
Seriously. I got to meet him with some classmates last year and he seemed kind of peeved that the book was available to download. I saw it broken down somewhere the ROI of buying his book when it was published and selling it now. Handily beat the S&P if I remember correctly.
HighYielder Wrote: ------------------------------------------------------- > LOL. If I had an actual copy, i’d sell it to > someone real cheap. $800 bucks. Define financial irony - a book on value investing retailing for $2,000.
> Do we assume that every business in the same industry has the same PPE age and structure and therefore are comparable? That’s it. You’ll notice that the other important value driver, growth, is also ignored, or stated better it’s assumed the same. For mature firms in the same industry, EBITDA multiples can be compared. > Because it removes the impact of financing large capital investments and depreciation from the analysis, EBITDA can be used to compare the profitability trends of, say, “heavy” industries (like automobile manufacturers) to high-tech companies. Actually, that’s exactly why it can’t be used to compare an auto firm to a tech firm.
Dwight Wrote: ------------------------------------------------------- > Are you reading an actual copy or the online > version? Just curious. PDF acquired somehow on this forum, give a search here or google, sure you’ll find it.
I’m still a little hazy on why PE firms would use EBITDA instead of FCF. 1. I understand that EBITDA is much easier to calculate, but to me it seems like PE funds would need an even more precise valuation than say, a long-only mutual fund. Further, the universe of companies under the microscope of a PE fund is absolutely miniscule relative a mutual fund. Why wouldn’t a PE firm go to the trouble to calculate the most accurate valuation possible? The idea of a PE fund using EBITDA over FCF because it’s quicker and easier doesn’t seem to hold water to me. 2. If EBITDA is more useful than FCF to understand operating efficiency within an industry, that seems like a very small piece of the puzzle. PE funds often target companies with solid profitability and FCF generation IN SPITE of inefficient business models/management teams. Finding a company with poor efficiency that is still generating decent FCF seems like a PE fund’s ideal investment. Like I said, it seems like a small piece of a much larger puzzle.
bchadwick Wrote: ------------------------------------------------------- > , though they author recommends > EBIT - DAC, whatever DAC is. From the very bottom of the article: “For the record, in Europe, EBITDA minus capex is denoted as EBIT-DAC or EBITDAC.”
apcarlso Wrote: ------------------------------------------------------- > I’m still a little hazy on why PE firms would use > EBITDA instead of FCF. > > 1. I understand that EBITDA is much easier to > calculate, but to me it seems like PE funds would > need an even more precise valuation than say, a > long-only mutual fund. Further, the universe of > companies under the microscope of a PE fund is > absolutely miniscule relative a mutual fund. Why > wouldn’t a PE firm go to the trouble to calculate > the most accurate valuation possible? The idea of > a PE fund using EBITDA over FCF because it’s > quicker and easier doesn’t seem to hold water to > me. > I agree. I didn’t want to press the issue for fear of looking completely daft. I think it boils down to: A) convention: “we’re all dumb together, but we’re well paid, so why does it matter?” B) something about the data. It’s one thing to do a hard look at FCF about the company you are investing in, but if you are trying to find deal comparables for other firms, you may not have access to sufficient data to do a full FCF analysis on the comparables. So you do EBITDA. Still sounds a bit lazy, but I haven’t done it. C) Some really deep reason that is beyond me. I was hoping numi might chime in with his PE perspective.