Why I Believe EBITDA IS A BAD METRIC for Valuing Companies
When it comes to investing, I've learned that numbers can be deceptive if you don't look beyond the surface. One metric that often leads investors astray is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). I'd like to share why I believe relying on EBITDA can be misleading and how I've shaped my investment approach to focus on more meaningful measures.
This is not investment advice—just my opinion. There’s a lot of theory crafting behind these concepts, but here’s a high-level overview of my approach. This is for information-sharing and sparking conversation.
Article Contents:
The Limitations of EBITDA Across Industries
EBITDA is commonly used as a quick gauge of a company's financial performance, but it has significant shortcomings that can distort reality, especially when considering the nuances of different industries.
Depreciation isn’t just an accounting entry—it’s a real cost representing the wear and tear on assets that need eventual replacement. Imagine a trucking company buying a fleet of trucks; in ten years, they’ll need to be replaced. Ignoring depreciation in valuation inflates profitability and underestimates necessary reinvestments.
In asset-heavy industries like steel manufacturing or equipment hire, depreciation is a core cost, as these companies rely heavily on expensive machinery. Overlooking it can lead to overvaluation and misjudging future capital requirements.
For labor-based companies like fabricators or erectors, vehicles are essential for site operations and require ongoing maintenance. These costs, critical to business continuity, are often ignored in EBITDA calculations.
Interest payments and taxes are unavoidable financial obligations that directly impact a company's cash flow. Excluding them from analysis can give a skewed view of financial health. Interest reflects the cost of borrowing, and taxes affect how much money the company actually retains. Ignoring these factors can result in overestimating a company's ability to generate cash and thus sustain returns and illiquidity compensation.
EBITDA should be used a basis to determine the efficiency of ratio on Depreciation or other such schedules - and can capture gap-based efficiency. Indeed in my opinion even a net profit is a so-so metric of determining a good investment or a basis of valuation, what really determines valuation is sustained structured management (which is intangible) and systems with cash flow which can be reinvested or distributed to provide return on Equity Purchased with investment which is in excess of Inflation + Opportunity Premium (Personal)
EBITDA Overlooks Industry-Specific Expenses
Before jumping into in the above - this doesn't even consider upgrading the sewing machine due to efficiency and automations - or anything else - you will absolutely need to replace it and that interest is a real expense and needs to be considred into the valuation factoring - but you also need to adjust your metric as a real return needs to be on BBSW (bank swap rates) + Opportunity Cost adjusted for Active Participation in Investment (For me)
In tech companies, the shortcomings of EBITDA are even more pronounced. Research and development (R&D) is the lifeblood of these businesses. It's not just an expense but an investment in future viability. Treating R&D as an add-back in EBITDA calculations can misrepresent a company's ongoing cost structure and future potential.
In a steel trading company EBITDA will be close to useless as the utilisation of inventory and the days of inventory will determine profitability over anything else due to the $ value of inventory. Or in Hospitals it will be the land - the land might be 4x the revenue, even if EBITDA is 20% so what? When the capital for setup required would be 4x that thus the relevant metric will be return on assets adjusted for capital gains on land... it becomes a business of property development of sorts in a specific niche...
Or looking at the franchise model of mcdonalds...
I view R&D similarly to the cost of goods sold; a healthy investment in R&D is a positive indication of innovation and competitiveness. Ignoring these expenses can paint an unrealistic picture of profitability and growth potential.
In software services companies, EBITDA may closely mirror net income due to minimal depreciation and amortization. This can give a false sense of profitability by overlooking crucial cash flow elements like client acquisition costs, employee retention, software maintenance, and revenue recognition models. These factors are essential for sustaining and growing the business but are often ignored in EBITDA calculations.
Focusing on Free Cash Flow and Custom Metrics
Given these shortcomings, I prefer to concentrate on the actual cash remaining after all expenses—free cash flow. This includes adjustments for accounts receivable, inventory, and accounts payable. By analyzing custom metrics tailored to each business, I aim to understand its structure and real cash-generating potential over the next ten years.
In tech companies, for instance, I consider research expenses as essential investments, much like inventory in traditional businesses. A strong commitment to R&D isn't a burden—it's a sign of a company's dedication to staying competitive and innovative.
By focusing on free cash flow, I'm looking at the money that can be reinvested into the business or returned to shareholders. This provides a more accurate picture of financial health and future potential than EBITDA ever could.
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My Investment Philosophy
One of the radical underlying #1 decision maker before anything else for me is the continuous investment in R&D I want atleast 30% FCF of each company I invest in to go back to R&D in: Software, Hardware, Systems, Training, Tools and more! I have a hypothesis of my time and fund investment - R&D and culture of continuous R&D in an entire organisation will provide me excess returns and reduce my risks.
When investing, I determine what my capital's opportunity and risk are worth. My objective is to achieve an annual return of around 50% annually on initial invested capital after a 5 to 10-year period illiquidity, through active participation where dividends can be sustained. This is personal - and it is based upon my theory of value creation and management structuring - and what it will require for a business to create cash flow to get an investor a sustained return of that. I do not think about things like % gains on valuation or non-intrinsic value drivers - it is cash specific basis - or in a case of IP based business - an Exit specific milestone structure. I recognize that in the initial years, there may be minimal or no returns as it takes time for the business to start generating positive cash flow. There's a tradeoff between immediate returns and long-term growth potential. (Note I do this at a relatively small scale currently - I do not know if this is even scalable to anything after $500m)
This doesn't mean I'm a dividend investor. If a growth opportunity presents returns above inflation, I'm inclined to guide stakeholders toward reinvesting profits back into the business. If the business model is working and I've already invested in it, I don't prioritize an excess premium. I won't liquidate my position as long as it continues to improve and slightly exceed inflation.
Why would I sell a stake in a proven team and model that's consistently delivering? New investments come with risks—the need to understand new markets, new teams, and new dynamics. With a successful, cash-flowing business, my goal is to preserve capital and potentially never sell. In the long term, this approach often yields better results.
Instead, I can use dividends from a successful business to fund other ventures or take calculated risks. This way, I'm leveraging existing success to explore new opportunities without jeopardizing my initial investment. It's about building a solid foundation that allows for sustainable growth and capital preservation.
What I Look for in Investments
I focus on several key factors when evaluating potential investments:
I examine the company's cash reserves and how previous shareholders managed the business's finances. A healthy cash position indicates prudent financial management and provides a buffer during economic downturns.
Hard assets add intrinsic value and can serve as collateral if needed. They often provide stability and can enhance the company's ability to generate revenue. In industries like steel manufacturing, owning assets like land or facilities can significantly reduce operational costs.
For example, owning land outright in high-cost cities like Sydney can save up to 10-15% of revenue. This ownership reduces overhead, allowing the company to offer more competitive pricing or enjoy higher margins. While this might lower the Return on Assets due to capital tied up in property, it provides flexibility in capital structuring and enhances long-term stability.
A company that's been performing well for over five years and hasn't aggressively expanded into new divisions shouldn't carry high debt. Organically growing businesses should have minimal to zero debt because net profits can often fund growth unless the business is extremely staff-heavy.
I delve into the risks associated with customer contracts and competitive forces. Understanding how a company can increase its competitiveness is crucial. Whether it's through operational efficiencies, unique value propositions, or strategic asset ownership, these factors can significantly impact long-term success.
In the steel industry, for instance, investing in land or equipment can enhance competitiveness. In tech companies, continuous investment in R&D keeps the company at the forefront of innovation. Recognizing these strategic moves helps me assess the company's potential and resilience in changing markets.
Integrating It All Together
By focusing on free cash flow and custom metrics, I aim to gain a deeper understanding of a company's true financial health. This approach allows me to make informed decisions about where to allocate resources, whether to reinvest profits, and how to structure investment strategies that align with long-term goals.
Ignoring EBITDA isn't about dismissing conventional metrics for the sake of it; it's about recognizing that one-size-fits-all metrics can be misleading. Each industry has its own dynamics, and a nuanced approach is essential for accurate valuation.
Investing isn't just about surface-level numbers; it's about comprehending the underlying financial dynamics of a company. By focusing on the actual cash flow and setting clear, realistic return expectations, I aim to make investment decisions grounded in actual performance—not inflated metrics.
It's also about partnering with proven teams and business models, preserving capital, and thinking long-term. Instead of chasing quick returns, I believe in building sustainable growth that stands the test of time. This approach allows me to leverage existing successful investments to explore new opportunities while mitigating risk.
In essence, my investment strategy is about understanding and embracing the complexities of each business, rather than relying on oversimplified metrics like EBITDA. It's about the journey of growth, the partnerships formed, and the long-term value created—not just the immediate financial gains.
I hope whoever read this understood the intent of me writing this and can share there own thoughts on their investment school of thoughts - mine is still in formation as I structure my learnings and other people's learning through keen observation of what works in a horizon of 10-50 years as I focus specifically in private small/ medium businesses - why? I see a potential at my current capital level to control and generate excess returns through active participation and gain freedom to focus on Research and Crazy Ideas.
IF you read this and comment and like (I get 7+) I will share an acquisition analysis of a small steel business I am doing right now!