Rage against the EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is often used by sophisticated investors to price companies. A sample valuation statement can be "XYZ company is trading at 5x mid-cycle EBITDA and presents a compelling opportunity." 5 times means its enterprise value (equity + net debt) divided by EBITDA is 5 (a 20% yield).

The traditional explanation is that EBITDA is a proxy for cash flow that is capitalization (debt) agnostic and allows for a less noisy picture of the earnings power. In more practical terms, a buyer of a company often changes the capital structure (by paying off/adding additional debt). The current debt structure is merely the financial decision by management and often has little to do with the underlying business.

The cynical explanation is that EBITDA, by ignoring capital expenditures, is often a misleading metric. Combined with metrics such as "adjusted EBITDA," these metrics are often used to justify high prices for transactions. 10mm EBITDA is really 5 mm if there is 5mm of maintenance capex expected.

More specifically:
1) Interest and Taxes are paid by the company and do not belong to shareholders. Sure, companies may choose a capital structure with less debt and pay less in interest. But that by definition means companies have less cash to deploy to make money. More fundamentally, companies profit from what is, not what could be. If a company is under/over-levered, is that not just a reflection of the company's management and should be evaluated? Other than in LBO situations, debt is part of what one buys. Such buyout perspectives should not be the main source of valuation, unless you are selling to a LBO sponsor!

2) Depreciation and Amortization (D&A from capital expenditures/goodwill from acquisitions) is actually a benefit to company financials. It allows the smoothing out of large expenses to buy equipment, etc. when the benefits of the expense is over the long term. Backing out D&A should also mean a car company doesn't need a factory to make cars. Now, if there is a one-time capital expenditure that will not repeat for many years (longer than the depreciation period), then maybe it is work considering. The workaround of EBITDA minus average (maintenance) capex is in fact D&A anyways. A similar analogy applies to amortization of goodwill.

Bottom line, using EBITDA can easily lead to overestimation of earnings power, which conveniently allows higher selling prices! EBITDA used and adjusted correctly usually results in roughly the same as averaging 10-year GAAP financials in most cases. As a result, I have little faith in EBITDA..