Many people consider EBITDA (earnings before interest, taxes, depreciation and amortisation) to be a useful measure of corporate profitability. They’re mistaken. Not only is EBITDA useless, it is also potentially misleading.
Take the depreciation element. Depreciation is not something that can be breezily disregarded as not really that important. It is a device that spreads the cost of historical investment by the company’s management over the expected life of the asset. As Warren Buffett is credited with saying: does management think the tooth fairy pays for capital expenditure? Turning a blind eye to depreciation is, at best, self-deluding.
Show me a company with a meaningful depreciation and amortisation charge that is spending nothing on capital expenditure and I will show you a business that will fail over time
Depreciation works on the same principle as stock option expensing. Giving employees economically valuable stock options is clearly part of their compensation and so is treated as an operating cost, even if the intrinsic value of those options is zero when issued. Any metric that can be described as ‘profits before costs’, as is the case with EBITDA, is inherently suspicious. I have yet to come across a company that uses EBITDA internally.
EBITDA is often treated as a proxy for cashflow. It’s not. Show me a company with a meaningful depreciation and amortisation charge that is spending nothing on capital expenditure and I will show you a business that will fail over time. The bigger the depreciation charge, the less credible it is to operate with minimal capex. For some reason, lenders still use EBITDA for debt covenants, as if all the EBITDA sum was magically available for debt servicing.
The EBITDA lovers
Capital-intensive industries love EBITDA. A company with a 5% operating margin and a depreciation and amortisation charge of 10% of sales will produce an EBITDA figure three times higher than its EBIT. No wonder the company wants to focus on EBITDA – it’s an exceptionally flattering metric.
From an investor’s perspective, though, high capital intensity is usually undesirable, as rapid growth will require heavy investment. Capital-intensive companies often also tend to have a high operational gearing, so their margins will come under heavy pressure in recessions.
It should be clear where we’re going with all this by now: EBITDA metrics tend to overvalue low-margin businesses. Industrial companies, for example, tend to trade at around times 10 times EBIT and seven to eight times EBITDA. In theory, they are worth about 50% of their sales on an EBIT basis but 105%–120% of the same sales on an EBITDA basis. Only one of these outcomes can possibly make any sense, and I suggest it is the former.
Wheel suckers
I used to follow a truck company with an operating margin of 6% and a fully consolidated leasing business. It had regular depreciation of 4% of sales (buildings, machinery, etc) but another 6% of sales for the depreciation of the lease fleet. It got taken over by a private equity company – and private equity businesses tend to use EBITDA metrics as EBITDA determines an entity’s maximum debt burden.
Now the truck company’s lease fleet depreciation was a pure operating cost, as the fleet had to be continually renewed just for the business to flatline, let alone grow. I can’t prove it, so I’m not naming names, but I am certain that the private equity company overpaid massively to acquire the truck business because it used the 16% EBITDA margin for its valuation. It then levered it to five times EBITDA to try and recover the excessive price it had paid.
Lost rationale
Before IFRS Standards became the de facto global standard, there was good reason to use EBITDA. Because some countries had depreciation policies that reflected the national tax treatment, depreciation periods were very short.
Under the HGB German commercial code, for example, some companies reported depressed EBIT margins for this reason. It was easier to use EBITDA than to adjust the EBIT to an economically sensible level. This was never a good solution, but the rationale for it disappeared many years ago.
There is simply no valid justification for using EBITDA today and a great many reasons to avoid it.
The next time you see a company or sector using EBITDA, just ask yourself: what are they trying to hide?
