EBITDA (Earnings Before Interest, Depreciation, and Amortization) has become a standard tool in assessing a company’s valuation, ever since it started to be used as an integral component of an LBO strategy in order to determine how much debt a company can handle.
However, there are certain figures and numbers that aren’t factored into EBITDA’s calculations, making it possible to come across disparities when trying to uncover the actual valuation of a company.
Three costs, in particular, are not included in the EBITDA calculation:
Capital Expenditures – Industries including oil and gas, telecom, shipping and aviation require a substantial investment in equipment. Yet EBITDA does not factor in capex (the line item representing the investments in plant and equipment). If fact, ignoring capital expenses (in order to inflate EBITDA) is what preceded the bankruptcy of WorldCom.
Depreciation – When a company adds back all depreciation without providing room for capex, their cash flow will likely be overestimated. Inversely, if a company does not add back any depreciation, the cash flow can be underestimated (particularly if the company used accelerated depreciation). Depreciation schedules have been manipulated in the past (in an effort to inflate EBITDA), such as in the 1990s, when Waste Management extended the lives of its garbage trucks, thus overstating their salvage value.
Working Capital Adjustments – EBITDA does not account for changes made in working capital, which results in the assumption that a business is paid prior to even selling products. But most companies operate the same way: they provide a service or product and are compensated for it afterwards.
By omitting these three costs, which EBITDA does not factor in, a company’s cash flow tends to be inflated beyond its true calculations. Analysts and buyers must consider fixed costs, including working capital requirements, debt payments and taxes, because if the business wants to grow and remain profitable, it needs to have the cash available to finance these obligations.
But when a buyer relies on EBITDA to determine valuation, these costs are hidden under wraps. Company owners can adjust (or leave out) certain calculations in order to inflate EBITDA and make their company appear to have more cash flow than it does.
EBITDA can be useful in offering loose comparisons between two companies of the same ilk; however, when relied upon as a standard tool for assessing cash flow, it simply comes up short.
In fact, many view references to EBITDA can sometimes be overly used and greatly misinterpreted. While it has its uses, it should not be relied upon as a complete valuation tool to aid in the decision of an investment opportunity.