EBITDA: Too Popular by Half

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Synopsis

EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization. Multiplying EBITDA as a way to value businesses and ownership interests in businesses:

  1. is said to have first been adopted in the United States in the 1980s.
  2. gained popularity in Canada in the early 1990’s.
  3. currently seems to be gaining ever more traction around the world with investment bankers, stock analysts, business valuation advisors, financial advisors and business owners.

The phrase too clever by half refers to someone who is too clever for their own good. By inference, too popular by half in reference to EBITDA is taken here to mean too popular in the context of its usage as a business value metric.

This commentary:

  1. explains the multiple of EBITDA business valuation methodology.
  2. discusses reasons it ought not to be generally adopted as a primary business valuation methodology – irrespective of whether the valuation is required for open market sale or any other purpose.
  3. quotes others who have big reputations in the investment community as to their views on the validity of the EBITDA methodology.

Overview

Many business owners and advisors seem enchanted with EBITDA. They claim various professional and other sources as credibility for adopting multiples of EBITDA as a primary business valuation methodology, and for the EBITDA multiples they adopt. This where there seems to be:

  1. a large element of consistency in what they are reading and evidentially being told as to the practicality and efficacy of the EBITDA valuation methodology.
  2. an increasing adoption of EBITDA as a valuation methodology in business owner thinking and planning – including transition planning.

This is troublesome because the simple arithmetic some business owners are adopting may result in misleading value biases and conclusions that may not square with reality in their individual circumstances.

My background and experience

Readers will find the views I express here to be contrary to the apparent views of many investment bankers, analysts, and business valuation advisors. I see little point in spending time with views and opinions that lack credibility. Hence, and with reluctance, I am stating a brief summary of my background. Readers then can determine if they want to hear what I have to say on what I think is a very important business valuation issue. Here it is.

  1. Beginning in 1970 and for the next 30+ years I was instrumental in the development of the practice of business valuation consulting in Canada.
  2. In 1972 I founded, and for four years managed, the business valuation practice of what today is one of Canada’s largest public accounting firms.
  3. In 1976 I founded, and until 2004 managed, one of Canada’s foremost independent business valuation consultancies.
  4. Over more than 45 years I advised hundreds of Canadian business owners and their professional advisors with respect to business valuation – some of whom engaged me to advise them on business transition planning, and others of whom engaged me to advise them on the sale of their businesses.
  5. When practicing I testified frequently in business valuation matters before Canadian courts, Commissions and tribunals in appraisal/‌‌oppression remedy shareholder dispute matters, in income tax cases, and in cases dealing with Canadian securities law.

History of EBITDA usage as a business valuation metric

It is suggested by some that EBITDA was first used in the 1980’s as a single number to be used as a proxy for a company’s ability to generate cash.

I first observed multiples of EBITDA used as primary business valuation metrics in the early 1990’s when I saw Canadian investment bankers begin to adopt EBITDA multiples:

  1. to generate public company values in “going private” transactions when they stated a transaction was, for offerees, “fair from a financial point of view”.
  2. when they issued so-called “fairness opinions” for public investor consumption where such opinions were required by a securities regulatory authority.

Over time use of a multiple of EBITDA valuation methodology seems to have gained an increased level of adoption and perceived credibility among many members of the investment community, business valuation experts, and by osmosis business owners. This in my view where if enough people say that a goose is a duck, more and more people who should know better follow them over the “lemming cliff”.

The multiple of EBITDA valuation methodology explained

The multiple of EBITDA methodology relies on “comparability multiples” that typically are calculated based on either – or a combination of – two decidedly different metrics. Those are the results obtained when the:

  1. market capitalization of a publicly traded company is divided by the latest 12 month EBITDA publicly disclosed by that company. This same calculation is made in more than one company in a given industry or industry group, and typically some form of averaging is done to generate an “EBITDA multiple to be adopted in a particular valuation”.
  2. price paid in an open market transaction by an arm’s length purchaser for a company – public or private – is divided by the latest 12 month EBITDA publicly disclosed or privately known for that company. Again, this same calculation is made in more than one company in a given industry or industry group. Again, typically results of those calculations are averaged.

Each of those two different groups of calculations has a different basis, and each should yield a different result. This is because:

  1. The first, based on public market trading prices, does not de facto include incremental cash flow – read synergistic cash flow – that may be available to a purchaser of the entire company.
  2. The second, in my experience, most often inherently does consider post-acquisition synergies.

Determination of “enterprise value”

The enterprise value of a company is the sum of its outstanding interest bearing debt adjusted for favourable or unfavourable interest rates and the imputed value of the company’s shareholder equity. Simplistically, enterprise value is developed by multiplying a multiple – the inverse of a rate of return – by an EBITDA amount, referred to by some as “normalized EBITDA”. This where a normalized EBITDA is presumed on average to be the prospective annual EBITDA the business is expected to generate as at the date of valuation.

The result is then adjusted to account for the value of redundant assets owned by the business if there are any, and for further adjustments for things such as working capital and contingent liabilities, to derive a total enterprise value.

Normalized EBITDA

Properly addressed, so-called normalized EBITDA is multiplied by an EBITDA multiple typically derived from overview analysis of public equity market and published takeover prices. Important issues arise here that self-evidently conspire against the veracity of the EBITDA methodology.

Again, normalized EBITDA is a term used to describe an EBITDA number – or range of EBITDA numbers – developed as an expected future annual result. Generally normalized EBITDA is based on analysis of historical and current operating results commonly adjusted for things such as:

  1. non-arm’s length discretionary expenses.
  2. non-recurring and anticipated changes to and in prospective revenues and expenses.
  3. income and expenses related to redundant assets.

Determining an appropriate EBITDA multiple

Selection of appropriate EBITDA multiples requires that a number of assumptions be made and taken into consideration when deciding on the multiple or multiples to be adopted.

Importantly I do not believe it is sensible to assume all of the following things are incorporated in “comparable company information” when not enough detail is typically known about “comparables selected” to consider them meaningful in the first place. A non-exhaustive list of these assumptions includes:

  1. the business’s existing and prospective corporate governance standards, and how those things may impact the prospective free cash flow of the business.
  2. the quality of management, and prospective management and key employee continuity.
  3. how each of globalization, central bank policies, and government intervention and regulation are likely prospectively to influence the free cash flow of the business.
  4. prospective competitive advantages or disadvantages in the face of ongoing business combinations – including business combinations of the business’s suppliers and customers.
  5. business size, brands, market penetration, etc. as compared to competitor businesses both currently and prospectively.
  6. business optimal and actual debt levels.
  7. prospective changes to selling prices and input costs.
  8. the expected comparative growth rate, or lack thereof, after the valuation date where that growth rate is not imputed when developing normalized EBITDA.
  9. anticipated changes to required working capital levels beyond the valuation date.
  10. importantly, the level of sustaining capital and growth capital expenditures that on average will be incurred annually beyond the date of valuation having regard to:
  • the maintained and technologically competitive states of the capital assets of the business as they are at the valuation date.
  • the impact ongoing technological advances seem likely to have on the free cash flow of the business.
  1. prospective business income tax rates and other government levies that are jurisdiction specific.
  2. fundamental differences that exist between public and private companies. See Public and Private Company Differences where 50 important differences between the two are summarized. https://goo.gl/bToFre

Importantly all of foregoing would be included in any responsible post-valuation date forecast generated by company management and approved by its Board of Directors:

In short, unless adjusted for a myriad of factors, discussed later – simplistically developing EBITDA multiples for me is akin to going into a forest, finding a group of poisonous and non-poisonous mushrooms, putting them in a common pot with soup stock, and making and then eating the resultant soup. No sensible person would do that.

The bottom line: How much reliance should be placed on the EBITDA business valuation methodology?

In a nutshell:

  1. no one can question the comparative expediency of the EBITDA valuation methodology.
  2. I do not believe business owners should rely on a valuation of their business where they or one or more of their advisors adopts the multiple of EBITDA valuation methodology as a principal valuation methodology.
  3. perhaps with the limited exception of non-capital intensive pure service business the multiple of EBITDA business valuation methodology is at best an enabler of business value approximations – read litmus tests.
  4. if used at all, the EBITDA business valuation methodology is still best used as an “approximation test” of results developed from a detailed discounted free cash flow business valuation analysis.

Specifically why is the EBITDA business valuation methodology flawed as a primary business valuation methodology

Important reasons the multiple of EBITDA business valuation methodology is flawed in the context of it being a reliable primary business valuation methodology include:

  1. The requirement that many important value related variables inherently are subjectively included in the selection of an appropriate multiple.
  2. It does not account separately for either sustaining or growth capital expenditures (Capex), and hence inherently and subjectively accounts for these things in the EBITDA multiple selected.
  3. It relies to a large extent on comparable transaction multiples, financial markets, or other proxies some of which (1) may be inclusive of post-acquisition synergies that have been in some manner accounted for in the purchaser’s detailed price determination methodologies, and (2) absent the involvement of those adopting so-called comparable transactions who have hands-on knowledge of the inner-workings of those transactions there typically is not enough publicly available detailed information available for one to draw very much meaningful from those so-called comparable transactions.
  4. It does not account separately for differing corporate income tax rates where the “so-called comparables” used may do business in one or more taxing jurisdictions that levy different business tax rates than do the taxing jurisdiction(s) of the business to which EBITDA multiples are applied.

Quotes about EBITDA

Here are selected quotes from people you have likely heard of.

  1. Charlie Munger, Berkshire Hathaway: “I think that, every time you saw the word EBITDA [earnings], you should substitute the word “bullshit” earnings. People who use EBITDA are either trying to con you or they’re conning themselves.”
  1. Seth Klarman, Baupost Group: “It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company‘s ongoing income stream. Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.”
  1. Bill Hanneman, Zachary Scott: “EBITDA multiples are quick and convenient to calculate, but these attributes are precisely its downfall.”

Suggested reading

  1. Why You Can’t Trust EBITDA. Nasdaq, August 2017.
  2. What’s Missing in EBITDA? Divestopedia, October 2017.
  3. EBITDA is ‘BS’ Earnings. Forbes, November 2014.
  4. The Appeal of EBITDA Multiples. Zachary Scott, October 2002.
  5. Munger, Klarman and Buffett on EBITDA. GuruFocus, May 2015.
  6. EBITDA business valuation methodology: How reliable? Business Transition Simplified, February 2015.

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Ian R. Campbell FCPA FCBV

Ian R. Campbell is a Canadian business valuation and transition expert. He is the author of several Business Valuation texts and of 50 Hurdles: Business Transition Simplified. The Canadian Institute of Chartered Business Valuators recognizes his contribution to the Canadian Business Valuation Profession through the annual The Ian R. Campbell Research Initiative.

He writes The Business Transition and Valuation Review newsletter for business owners and their advisors.

You can reach him by email at icampbell@ircpost.com, or by telephone at 905 274 0610.