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EBITDA is a widely used number right across finance. Despite its wide use, it comes in for some heavy criticism, often unfairly.

Let’s start by understanding what EBITDA is not. It is not a proxy for cash flow. EBITDA is before tax, operating working capital, and capex, so even in the least asset-intensive business it still would not be a complete proxy for cash.

Analysts like to think about businesses using their Enterprise Value, and so want an earnings number before finance costs. You could consider using EBIT (cleaned operating profit), but there are two problems.

First, and less importantly, companies have different accounting policies for amortization and depreciation. So, while one company might depreciate an asset over 10 years, another may choose 15 years and have a corresponding lower depreciation expense. 

Second, and far more importantly, companies must revalue assets in acquisitions, even if the assets were developed internally. So, a company which has made acquisitions will have recorded more PP&E and intangibles on their balance sheet than the individual businesses would have expensed individually. 

So, if you are comparing companies, then plain EBIT will penalize the acquisitive companies unfairly. Even EBITA has issues as it won’t strip out additional depreciation from net PP&E step-ups (although for service-based businesses it will be pretty good). EBITDA is used to strip out the impact of these differences when comparing two companies. 

You must be more careful when using it as an absolute metric as it is not cash and does not incorporate the very real cost of fixed assets. There are different situations for which EBITDA is calculated and they will drive what is included and excluded in the calculation. 

EBITDA used in valuation and investment banking

You can use EBITDA for valuation purposes as a relative value tool, in other words, where you are comparing companies in the same industry. Be careful of very asset-intensive industries where capex is a key differentiator, in these cases you might want to calculate EBITDA – capex. Assuming the industry is not that asset-intensive then calculate EBITDA in the following way:

Ensure you clean operating profit of non-recurring items and then add back depreciation and amortization. If you take depreciation and amortization from the cash flow statement, be careful there aren’t any impairments embedded in the non-recurring items which you will have already adjusted for. 

The cash flow statement usually starts with net income, which means that the depreciation and amortization number includes ALL depreciation and amortization, so if the company has discontinued operations, the amortization and depreciation number will include amortization and depreciation from the discontinued items.

Corporations usually disclose their own calculation of EBITDA in their earnings press release, or 8-K document if they are a publicly-traded company. You can start with these numbers but DO be careful. Here’s an example from IAC Inc’s letter to shareholders:

Note the above extract includes an adjustment for stock based compensation which would not be an appropriate adjustment for valuation purposes.

Stock based compensation

In the EBITDA example above, IAC breaks down the adjustments to operating income to calculate ‘adjusted EBITDA’. They add back depreciation, amortization, and contingent consideration fair value adjustments – all OK. However, they ALSO add back stock-based compensation. This is not OK. Stock based compensation is a real cost to shareholders and should not be adjusted for valuation purposes. Credit analysts often add back stock based compensation as it’s non cash, and in the short-term doesn’t hamper the ability of the firm to service debt. So, credit EBITDA is different from valuation EBITDA.

For IAC you should deduct the stock based compensation from their adjusted EBITDA number to get an EBITDA for valuation purposes:

Associate/equity method income

Another issue you have is whether you want controlled or consolidated EBITDA. In other words, should you include associate/equity income in EBITDA and should you embed associate investments/equity method investments in Enterprise Value?

Back in 1999, when Vodafone made the Euro190billion bid for Mannesman, a German telecommunications company, a key question was whether to include associate income in EBITDA for the purposes of Mannesman’s valuation. Back in 1999, the European mobile operators had made significant investments in the 3g license spectrum, following auctions by the national governments. Many of the operators were significantly leveraged, furthermore, they were also engaging in substantial capital expenditure rollouts of the new 3g radio masts. 

If they have a controlling interest in a group company, they could force the subsidiary to pay dividends to help service the debt in the holding company, and also coordinate capital expenditure spend with the rest of the group to generate economies of scale from joint purchases. 

If they had a significant interest in a group company, but not control (an associate investment/equity method investment), the associate earnings were valuable, but they could not force the entity to pay dividends, nor could they force the entity to spend caped inline with the rest of the group. 

The financial markets recognized the value of control, and valued controlled EBITDA at a higher multiple compared to associate income. In the transaction, the financial advisors calculated EBITDA in three ways:

  • Proportionate EBITDA: pro-rata consolidation of EBITDA, including the share of associate’s EBITDA, and subtracting the non-controlling interests share of EBITDA. The value of the associate investment is kept in Enterprise Value, and also an adjustment is no longer needed for non-controlling investments.
  • Consolidated EBITDA: including associate income in EBITDA, and including the associate investment value in Enterprise Value. All other adjustments such as non-controlling interests are made normally.
  • Controlled EBITDA: excluding associate income from EBITDA, and valuing the associate investment separately from controlled Enterprise Value.

The deal was eventually negotiated on a controlled EBITDA basis.

Vodafone’s definition of proportionate EBITDA:

EBITDA used in credit

The credit markets use EBITDA as a rough estimate of debt capacity. Although it’s dangerous to consider EBITDA as a ‘proxy for cash flow’, it’s still widely used. Remember, EBITDA is before taxes, investment in working capital, and capital expenditure. Credit analysts usually use historic earnings when calculating their ratios for a company’s existing debt / EBITDA ratio, and most commonly Last Twelve Months or ‘LTM’ EBITDA.

Credit analysts often use a bottom up approach to calculating EBITDA (from net income upwards), rather than Operating profit plus depreciation and amortization which is more common in investment banking. The bottom up approach might be because credit doesn’t necessarily care whether income is core or non core, as long as the income is sustainable and can help generate cash flow to service debt.

Standard and Poors definition of EBITDA is as follows:

+ revenue

minus operating expenses

+ depreciation and amortization

+ dividends (cash) received from affiliates, associates, and joint ventures

associate income

Problems comparing LTM EBITDA across sectors

Using Debt to LTM EBITDA as a leverage ratio is dangerous when comparing companies with very different cash conversion profiles. Take the example of a subscription company where customers pay upfront compared to a manufacturing business:

The media business converts $1 of EBITDA into 61.7 cents in free cash flow, compared to the manufacturer which converts $1 of EBITDA into just 40.6 cents in free cash flow.

Other adjustments you can make to EBITDA

Finally, there are still other adjustments you can make to EBITDA such as pensions. US GAAP usually expenses all costs of underfunded pensions above the operating profit line. If you treat pensions as debt, you need to ensure ONLY the service cost of pensions is included in EBITDA and not interest income and expenses related to the pensions, nor any amortization costs.

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