You are evaluating a Company and average remaining life of its PPE is say 8 years. As a Private Equiteer, you target investment period is say 4 years. This means, in your investment period, there will not be any significant CapEx. And now you have a choice between 2 companies, both having average remaining lives of their PPE more than your investment horiozn. Comparing their EBITDA multiple to base your investment decision (as opposed to EBIT multiple) would be quite sensible, right? My point is, if remaining life of PPE is LESS than your investment horizon, then you CANNOT ignore D&A, because D&A would add up to be part of your CapEx and an actual cash outflow, sometime within your investment horizon. But if remaining life of PPE is more than your investment horizon, you are using existing assets without any obligation of replacing them. So, you care more for EBITDA figure rather than EBIT.
^ further ⌠as a crude example⌠You buy a newly built commercial property and intend to hold for 4 years. Though you still accumulate D&A (non-cash) in your books, you will not actually have to spend it on repairs and rennovation. Whereas, if you bought relatively old property with intention of holding it for 4 years, you may have to significantly spend on repairs/rennovations. That is, turn previously accumulated non-cash D&A into an actual cash outflow (CapEx). So, your investment horizon and remaining life of PPE decides whether EBITDA or EBIT would be a better multiple for comparison. This is how i thought of it.
Good point. I hadnât thought carefully about that. But still⌠suppose the remaining life of the PPE is 8 years and you plan to sell the business in 5 years. Doesnât that mean that whoever buys is going to get stuck with a big PPE reinvestment in 3 years time? How is it that we can assume the buyer wonât consider this in the agreed purchase price? Effectively, youâre still going to need to cover 5/8 of PPE reinvestment during your ownership period, or take a discount at sell time because your PPE is old. If you have a non-PPE intensive industry, like consulting, then EBIT and EBITDA shouldnât be all that different, but that sort of thing strikes me as a special case, and not the general rule.
The way I understand it, PE firms use EBITDA because it is an excellent initial screening tool for a potential investment. This is because EBITDA is quick and easy to calculate, it is an excellent proxy for cash flow for the majority of companies PE firms like to look at, plus the PE firm does not have to expend too many resources to obtain a measure of cash flow. For example, most middle market PE firms will not look at any companies below $3M in EBITDA. Once the PE firm wants to take a closer look, it will then calculate FCF and look a little deeper into WC and prospective capex requirements etc. Additionally, PE firms get stacks of offering memorandums from IB firms that also use EBITDA.
FCF = whats left for investors after all investment opportunities have been exhausted. how is this useful for a small company that a PE firm evaluates? do they want to be looking at ANY small company that has free cash and nothing to invest in? the firms that are attractive are those with NO FCF and HIGH EBITDA. hell, Iâd even say that negative FCF is good if EBITDA is high. most prominant large caps today, needed endless capital in their early stages and had negative FCF for many years. if you have positive FCF, why donât you just host an IPO? PE firms allow negative FCF, high EBITDA firms to reach positive FCF, then they liquidate.
Matt, you get your awesomeness points for the week! This makes lots of sense. EBITDA doesnât make a lot of sense to use for traditional public company analysis, but I se makes a lot of strategy sense from a PE perspective, since a fundamentally profitable business that has cash flow problems is the optimal target, provided that operations can grow (VC) or be restructured (LBO) to resolve the problems. That makes a lot of sense!