Acquisition Marketplace Review - The Journal of Applied M & A Theory

Forget About EBITDA

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) gained prominence within the LBO community during the 1980s because it represented a number that could be used to determine the gross dollars that could be made available to service acquisition debt. At that time, EBITDA was more relevant because the deal criteria of the typical LBO sponsor excluded companies that required significant investment for capital expenditures, research and development, or inventory. Less re-investment in the company meant that a larger portion of the EBITDA was available to service acquisition debt.

EBITDA remains popular as an earnings base for determining purchase price multiples and investment returns, although its popularity far exceeds its usefulness. In fact, when it comes to acquisition pricing and analysis, EBITDA has a number of serious limitations. Taken together, the risk of using EBITDA is that you may very well pay too much for the following reasons:

  1. EBITDA is the most “gross” earnings base and it gives the appearance that more cash is available than there actually is.

  2. It’s the largest profit metric and makes multiples seem smaller.

  3. It doesn’t reflect the actual economic depreciation on the company’s assets.

  4. It makes a poor price multiple because the percentage of depreciation and amortization can vary from company-to-company.

  5. EBITDA is NOT cash flow.

  6. It does not reflect any increased demands on working capital.

  7. It does not reflect required capital expenditures.

  8. It does not reflect the costs of debt.

  9. It does not include changes in long-term debt.

  10. It does not include taxes.

  11. It does not represent the actual dollars that are available to service debt.

  12. It does not represent the dollars available for distribution to equity investors.

A far superior earnings measure is Free Cash Flow (FCF). MoneySoft’s DealSense Plus+ calculates both Free Cash Flows available to Equity (FCF-E) and available to Total Invested Capital (FCF-TIC).

FCF-E measures the amount of cash that is available to equity holders and is the appropriate earnings base for evaluating returns of Invested Equity. FCF-E is calculated as follows:

 	Net Income 
+ 	Non-Cash Charges (depreciation and amortization) 
-	Capital Expenditures
-	Changes in Working Capital
-	Changes in Interest-Bearing Debt
-	Preferred Dividend Payments
=	Free Cash Flow available to Equity

FCF to Total Invested Capital measures the amount of cash flow available to pay debt and equity holders. FCF- TIC is calculated as follows:

 	Net Operating Income
-	Taxes
+ 	Non-Cash Charges (depreciation and amortization) 
-	Capital Expenditures
-	Changes in Working Capital
=	Free Cash Flow available to Total Invested Capital

Again, the most fundamental danger of using EBITDA is that you will overpay. The earnings base will seem higher and the purchase multiples will appear smaller. Worst of all, you will not have a reliable estimate of the actual dollars available to the investors. So, do yourself a favor and follow the advice of Donnie Brasco’s would-be investment banker: Forget about EBITDA.

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