Is It Time To Ditch EBITDA In Business Valuations?

EBITDA or earnings before interest, tax, depreciation, and amortisation is widely used in the valuation of businesses. Where the value of a business is quoted in terms of a multiple of earnings the earnings used is not generally the net profit, the pre-tax profit, the after-tax profit or other profit figure. Instead, an EBITDA is calculated to remove those items like depreciation which don’t affect cash flow and are often used as legal ways of reducing declared profits with the goal of minimising tax liabilities.

There are some advantages with using EBITDA –  it focuses on just operational performance and ignores the effect of local taxation policies, companies’ capital structures and the extent of debt used in the business. And this particular useful in the sale of businesses as investors / acquirers may fall under different tax regimes and will almost certainly choose to use a different capital structure (thus affecting P&L charges such as interest).

However, there have long been complaints about EBITDA as a metric in these calculations. One major flaw is EBITDA’s lack of allowance for capital expenses. While removing depreciation, for example, has the effect of removing a non-cash charge to the profit and loss account, one does need to account for it somewhere as the asset does lose value and will need to be replaced at some point. The missing Capex adjustment is but one of the flaws in the use of EBITDA. This article argues the various grounds on which EBITDA as a metric should now be retired.

Warren Buffett agrees, and in 2002, for instance, said that “people who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs”

There are numerous examples of companies abusing EBITDA, a good example being WorldCom which overstated its EBITDA to the tune of $3.8 billion by moving expenses into assets.

The article argues that EBITDA overstates profit and should be avoided as a metric in the valuation of businesses.