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EBITDA is not the best indicator of earnings and cash flow

Updated: Dec 13, 2023

Most private companies are valued by a multiple of their adjusted, normalized EBITDA. The multiple is a proxy for how many years a buyer expects it will require to recapture their investment.

An EBITDA multiple of 3 suggests the buyer anticipates a annual return of 33%, and to earn their investment back in 3 years. An EBITDA multiple of 6 is a long-term investor, satisfied with a 16% annual return, and 6-year investment horizon.


But EBITDA tells, at most, two-thirds of the story. And oftentimes, less than half of the story. It very rarely approximates how much discretionary cash a company generates in a given year, for several reasons.


EBITDA is used as a universal earnings measure because everyone's tax and debt situations are different, so to make an apples to apples earnings comparison between businesses, you look at earnings before these varying tax and interest expenses.


But while that may be true of debt, with some companies big users of debt, and other's debt free, it is less true of taxes.


Unless there isn’t any 'e' in your EBITDA, taxes of as much as 30% or more will be levied against those.


EBITDA also looks at earnings before depreciation, given thier non-cash nature. In reality, those depreciation expenses represent capital investments in the past that will likely need to be repeated in the future if the business is to remain a going concern.


So, while you may not have a cash requirement behind this year’s depreciation within EBITDA, you will eventually, and that will be either a reduction to the cash flow EBITDA represents or the addition of debt.


EBITDA also does not account for investment of cash in working capital to generate earnings. A sizable portion of reported EBITDA may not be cash if working capital is growing rapidly.


Finally, a EBITDA valuation looks back, applying a multiple to earnings that happened in the recent past, while future earnings may be much higher or lower.


All of this is brought to light whenever you perform a Discounted Cash Flow ("DCF") analysis of estimated future earnings.


The DCF valuation is based on the future and starts with projecting EBITDA, before then deducting estimates for taxes, capital expenditures and additional working capital, resulting in cash earnings called Free Cash Flows ("FCF").


And Free Cash Flows are often 30-50% less than EBITDA, depending on a company's tax burden and how capital intensive it is.


FCF's are then further reduced in a discounted cash analysis to adjust for the effects of inflation and for performance risk.


The rate you use to adjust (reduce) Free Cash Flows for inflation and risk is called the discount rate, and a good way to determine what rate to use is to consider how much of a return you and the market would expect investing in a similar business. That is your discount rate. The more risk you perceive, the higher the rate of return you would expect. And the higher that expected rate of return, the smaller the purchase price must be to achieve that return.

You often end up with discounted free cash flows that are 70% less than projected EBITDA.


For these reasons, businesses will generally be valued higher with a multiple of EBITDA versus it's Net Prsent Value (NPV) of discounted future free cash flows.


Exceptions where higher values result from using Discounted future free cash flows include strong earnings growth and using a discount rate of 10% or less.


In those cases, it's future Free Cash Flows will equal or exceed it's historic EBITDA - even with the reductions by taxes, capex, and working capital - and the value assigned to earnings beyond the projected period are discounted at a lower rate because of the growth, increasing the exit value.


If I was selling a business wth typical growth expectations, I'd focus on it's EBITDA multiple value that does not account for the outflows after EBITDA, the time value of money, and risk.


If I was buying a business, I'd focus on the NPV of it's discounted free cash flows, to see how much cash is available after paying bills and making investments that come after EBITDA and gives me a tool to time value and risk adjust future earnings.



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