Thursday, September 20, 2007

Why I Hate EBITDA - Part III

The street has slowly shifted over time to using Enterprise Value to EBITDA (EV/EBITDA) as a measure of valuation for a stock. The ostensible reason given is that EV/EBITDA takes into account the entire value of the firm. The real reason is that since so many companies are unprofitable, there is no "E" to put in the price to earnings formula. Wall Street had to come up with another measure to use.

So what is wrong with EV/EBITDA? It gives a false sense of cheapness – I can still hear the voice of the sell side analyst ringing in my ear

"The stock only trades at 5 times EV to EBITDA – my god that’s cheap."

But is it really cheap. Here are two companies, which one do you think is cheaper?

Company 1

Mkt Cap $ 60.0
Bond Value $ 40.0
EV $100.0
EBITDA $ 13.0


Company 2

Mkt Cap $ 60.0
Bond Value $ -
EV $ 60.0
EBITDA $ 6.0

EV/EBITDA - 10.0

Well come on Eric, you say to me, the first one is cheaper you idiot. Well look again below.

Company 1

EBITDA $ 13.0
Interest $ 8.0
Free Cash $ 5.0

Price to FC 12.0

Company 2

EBITDA $ 6.0
Interest $ -
Free Cash $ 6.0

Price to FC 10.0

It doesn’t really matter what the EBITDA is because we all know that what really matters is the cash a business produces after it reinvests to maintain its business.

Don't be fooled by EBITDA. Wall Street hates you. Don't ever forget that their job is to separate you from your money.


Mark said...

I don't like it either. I also don't like companies that don't expense stock options and dilute the shares with them. I also don't like companies that buyback stock to boost eps or make up for the options dilution. I know some of the tech companies did this in the late 90's bull. I guess my perfect company wouldn't use options.

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Troy Peterson said...

Umm....your example is not really all that good.

For the company with $40 debt, you assumed 8$ after-tax interest expense, which means they are paying a pretax interest rate of 30% on their debt (assumes 33% tax rate). Most junk-rated issuers are well-below 10% cost of debt capital.

If you assumed 10% interest rate on their debt, then adjusted it for the tax shield= $40debt *10 interest%(1-.33)= $2.7 cost of debt. Based on $13Mln ebitda-$2.7Mln debt=$10.3Mln actual cashflow

Using your stated assumptions, this results in a price of $60/$10.3Mln cashflow....or approximately 6x P/CF ratio, relative to the 10x ratio for the debt-free company. As a result, EV/Ebitda in most rational cases is the best metric.

(Note- If EV/Ebitda mis-stated the actual cashflows and the company was paying 30% on its debt obligations, EV/Ebitda is still the most relevant it would have spotted the company whose debt you would want to buy! 30% sounds like a nice coupon to me :) )

So by m

Eric J. Fox said...


First, thanks for commenting. I was starting to think that Markopolis was my only reader. You are right, essentially I created an example to fit my argument. A 30% percent coupon is a bit high so I went back to the spreadsheet and adjusted it to a 10% coupon or $ 4 in interest, and then tinkered with the EBITDA of both company A or B and came out with a similar result although not as extreme.

Your second comment is right on also – there is a tax advantage to paying interest. I ignored taxes and you probably noticed that I excluded cash from the computation of enterprise value and I also assumed no capital expenditures for either company when computing free cash flow.

I think that if I searched long enough in the public markets then I could find a “rational” example of my argument. I will try to do so and publish it.

The point I was trying to make was that EBITDA does not equal free cash and this metric or measure has infected the street to a greater extent than I think it should.

In June 2000, Moody’s came out with an article called "Putting EBITDA Into Perspective: The 10 Critical Failings of EBITDA as a Principal Determinant of Cash Flow".

I have a copy in my office but can’t find it on the Internet anymore. I think you have to be a subscriber to Moody’s to get it. It's a good but difficult read and if you can find it, I would recommend it.

Troy Peterson said...

Yea its cool, not trying to sound like a know-it all, its just that heuristics both way usually fail when you try to make them an absolute rule.

I like the Charlie Munger quote about the cat that got on the hot stove and was burned. He never got on a hot stove again, nor a cold stove.

I dont like companies with debt either and usually it signifies a lower quality borrower thats not as cashflow-positive as they would want everyone to believe. However, thats not always the case and there are examples where highly levered companies trade at ridiculously low equity valuations versus their operating leverage....and get ignored because they arent profitable.

My other favorite quote is from Peter Lynch though, " Companies with no debt can't go bankrupt". Which is more difficult to argue with :)

Eric J. Fox said...

Maybe the Lynch comment should have continued "unless they have hidden off balance sheet debt that they never told investors about."

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