Business valuations – part 4

September 4, 2017

I spent yesterday afternoon with one of my boys making a gadget – a toy combustion engine given as a birthday present. I am not very handy with tools, gadgets and generally making stuff. Suffice to say the afternoon ended with an unfinished engine, a few band-aids on my fingers and some swearing under my breath.

EBITDA (earnings before interest tax depreciation and amortisation) is also a gadget that needs to be used with care.

Recall the simple formula for valuing a privately owned business:

Business value = Profit x Multiple

The last couple of posts have focused on the “multiple”. Turning our attention to the first half of the formula, which profit should be used?

Most of the time the choice is between EBIT and EBITDA. Before we make the choice, let’s find these two measures of profit in a standard profit and loss statement:

     $      % of revenue
Revenue 5,000,000
Cost of goods sold (2,750,000) 55%
Gross profit 2,250,000 45%
Operating expenses (1,000,000) 20%
EBITDA 1,250,000 25%
Depreciation and Amortisation (250,000) 5%
EBIT 1,000,000 20%
Interest expense (150,000) 3%
Net profit before tax 850,000 17%
Tax (250,000) 5%
Net profit after tax (NPAT) 600,000 12%

EBIT is sometimes referred to as operating profit because it ignores:

  • Tax – affected by the ownership structure (company, partnership, trust)
  • Interest – affected by the level of debt used to finance assets (if any).

Two identical businesses can have vastly different NPAT due to the tax effectiveness of the entity and the relative debt level. EBIT for the two businesses may also differ due to the way assets like equipment are depreciated. Meanwhile, the EBITDA will be the same.

EBITDA is the same as EBIT except that depreciation and amortisation (D&A) expenses are ignored (or added back). EBITDA is often referred to as cash profit because D&A are non-cash expenses. That is, depreciation is the accountant’s invention for spreading the cost of the equipment over a number of years, $250,000 in the example above, even though the equipment was purchased several years ago.

If you have followed the recent reporting season for ASX listed companies, no doubt you will have heard lots about EBITDA. Management of almost every listed company will explain their year on year financial performance with reference to EBITDA, or underlying earnings.  Bankers also use EBITDA in lending covenants as an indicator of debt repayment likelihood.

So what is the big deal? As my favourite literary Mark Twain pointed out “facts are stubborn things, but statistics are pliable”.

The fact is, depreciation is a real cost to a business and should not be ignored. Depreciation is an indication of how a business replaces its assets or acquires more assets to enable growth through capital expenditure. All businesses need to re-invest eventually, just look what happened to the McAleese Group.

EBITDA is an ok gadget for a first comparison between two identical businesses with different asset and financing profiles, but tells you very little about the quality of assets used.

Sure, the EBIT can be distorted by accelerated depreciation or deferring capital expenditure, but EBITDA is “bullshit earnings” according to Warren Buffett’s co-pilot, Charlie Munger.

EBITDA can drift from the realm of reality, much like my gadget making capabilities.

I will talk more about EBITDA multiples next time….

Lachie McColl