EBITDA Use with Caution

Earnings Before Interest Taxes Depreciation and Amortization (“EBITDA”) is often cited as a measurement of enterprise value. But the user must beware that this metric can be significantly misleading, and easily lead to a bad investment decision.

Briefly, EBITDA was a measure that had some quick-test meaning in the early 1980s. In part, that was an era when leveraged buyouts came into favor and EBITDA was thought to quickly test whether new debt load could be serviced.

But more importantly, before the 1986 tax reform act, major corporations (from a simpler economic time) and others with large cash holdings were able to cheaply acquire (bankrupt) companies that had large tax loss carryforwards. Those tax loss reserves could shield taxable income, which significantly raised the value of a company that could use that advantage.

That explains why tax expense, a very real cash use, briefly became irrelevant (in an acquisition target) until 1986. In 1986, with rare exception, the IRS eliminated the ability to cheaply acquire huge tax loss benefits to apply against the tax expense on other operations.

The elimination of Depreciation and Amortization (“DA”) in the metric was a short-sighted measure to approximate immediate operating cash flow. But it ignored the fact that DA reflected the use of real resources (equipment, facilities, and expiring/wasting intangibles) that would need replacing.

E.G. tooling for a new car line costs $5 billion, and that tooling has a product life cycle of 5 years. If $1billion in annual tooling depreciation is added back to earnings it significantly overstates the economic value of the car manufacturer. I.E., it could not distribute that cash equivalent to investors, without jeopardizing its on-going operation.

Some quick examples of EBITDA’s illogic -- with two companies having the same EBITDA ASSUME investor picks Company A over B (interest expense disregarded):

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NOTE: in contemporary Discounted Cash Flow valuation the third example is a close approximation of what is used, even if there is interest expense – interest is generally accounted for in the final return-on-investment discount rate.