Your EBITDA Multiple is Misleading You

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is often touted as the gold standard in business valuation. And a large number of banks use it to form opinions on a borrower’s ability to repay debt. It is often used interchangeably with cash flow or as a proxy for cash flow (specifically free cash flow to the firm). 

But not everyone is a fan. Charlie Munger, Warren Buffett’s longtime business partner boldly stated: “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

While we aren’t as critical as Mr. Munger of EBITDA and do think it has valid uses, a clue as to why he might say such a thing comes from his partner, Warren Buffet, in his 2000 shareholder letter, “does management think the tooth fairy pays for capital expenditures?”

The reason usually given for adding back the D and A is that they are non-cash expenses. This isn’t completely accurate. The accounting entry of recording a depreciation expense is indeed not recording any movement of cash. However, depreciation is a very real concept which is a reduction in value of the fixed assets of a company. And one day they will need replacement. And these capital expenditures will require cash.

Valuation isn’t about EBITDA. It’s about the cash return and risk in future time periods an investor can expect from an investment made in the present time period. The investor has a required IRR for that cash, and this drives the valuation. 

So, if company A was so inefficient that it needed to invest in twice as many assets (and twice as much cash) as company B to generate the same cash flow to the firm, EBITDA would never pick that up. Yet the investor in Company B would enjoy saliently better returns. And thus Company B would have a saliently higher valuation.

A better reason for using EBITDA than “it’s a proxy for cash flow” is that I,T,D, and A all represent expenses that will likely be different for a new owner than they are for an existing owner. So, looking at earnings before these can give an apples-to-apples measure of what will be transferred from an existing owner to a new owner.

A pure reliance on EBITDA multiples is also misleading for transaction expectation reasons. They are almost always published as a median of numerous transactions. Standard deviation around that median can be large. The median might be a 5.0X while many companies in the data-set transacted at a 4.0X or a 6.0X.  Depending on the size of the company, an increase of 1.0X in an EBITDA multiple can translate to millions of dollars (or not) in someone’s pocket. There are real and measurable actions owners can take to increase the chances their company will transact above the median and not below it.

When we set out to understand how much a company might sell for or how much to pay for a target, we start with the company’s cash flow and then start exploring realistic transaction scenarios for closing the price expectation gap between a buyer and seller. Numerous variables affect this: stock vs asset sale, amount and price of debt used, growth rates, asset efficiency, working capital efficiency, amount of seller financing, existence of a mezzanine financier, purchase price allocation, assets available within the company to use as collateral for financing, etc. We then pair this with a deep assessment of the maturity of the operations of the company. This informs the company specific risk component of the cost of equity which informs a buyer’s required return on cash which in a very large way, informs valuation. It is the price that makes the transaction happen, or in economics terms, the price that clears the market, that is the value of the company.

Yes, the enterprise value we calculate can be put in the numerator and EBITDA in the denominator. And, yes, we do record an EBITDA multiple for the potential transaction. But this is an output and a sanity check against other market transactions and not a driver of the valuation itself.