I was looking for some ideas to present but, I haven’t found anything much to my liking. Either I find companies that are following momentum or they have low valuation. When I combine the two, I still don’t too many companies that I would want to buy.
That’s my final criteria for presenting ideas to you all. Will I buy this myself? There’s nothing I find appealing given the precarious nature of this market.
So, I thought it might be a good idea to write an educational piece on something that is often debated among traders and investors - EBITDA.
I want to highlight some of the usefulness of the concept, dispel some of the myths surrounding this term and how we can use it.
Let me start off with a quote:
I adore Charlie Munger. Who doesn’t?
And I have no ground to disagree with him. But, there are reasons that we use EBITDA and it can be a useful measure in many circumstances.
Firstly, let’s just be clear. There is actually no GAAP Accounting term called EBITDA. So the EBITDA is a number we that we calculate and that’s why you’ll see it called Non-GAAP EBITDA.
We take Net Income (or Loss) and add back Interest, Taxes, Depreciation and Amortization.
We add back interest because it is variable and is seen more as financing cash flow versus operating cash flow. We add back Taxes also because this is variable and depends on the income generated. It also does not produce income or losses.
We add back Depreciation and Amortization because these are non-cash items.
We arrive at number that is meant to be akin to operating cash flow.
We also adjust EBITDA for one-time or non-recurring items so that we can get a sense of the basic earnings of the company that should persist year after year. So for example, if a company has a one-time gain on selling an asset, we will take that out of the earnings, because they are not likely to sell assets every year.
Given a choice, we should always be using cash flows - either operating cash flows or free cash flow to equity as the number to gauge debt service and earnings. So I wholeheartedly agree with Charlie on this.
However, there are reasons we use the EBITDA.
1 - Easier to compute and compare:
As bankers, we use this term because it’s easier for us to compute and compare this number between companies. It is also the basis on which we calculated our debt service amount. It is also the basis for valuation when we use EV / EBITDA (Enterprise Value to EBITDA).
As a side note, EV to EBITDA is a good measure of valuation particularly when a company has debt because EV = Market Cap + Preferred Shares + Minority Interest + Debt - Cash. It is the amount you would pay for company if you were to buy it today.
2 - Easier to find
Most companies will give you at least an income statement and balance sheet. Even with the most basic levels of these two statements, it’s often easy enough to calculate the EBITDA. Constructing a cash flow statement takes time if you don’t already have one.
Cash flow statements also depend on the changes from one period to the next so when we look at interim cash flows, the numbers can sometimes be distorted.
1 - Most companies will give you Adjusted EBITDA. This is a horrible number. They adjust whatever they feel like to the EBITDA number. The worst culprit these days is stock based compensation. Most companies make the argument that it is not a cash expense and therefore, it should be removed from EBITDA so what you get is a distorted version of reality.
2 - Warren Buffett has often used this argument for Depreciation and Amortization as well. He makes the argument that depreciation is a very real expense because the value of your assets are in reality declining with time and you will have to replacement. He looks at this as a deferred cost of replacement. He likes to avoid companies that have large depreciation or amortization expenses that may distort the EBITDA number.
Important Takeaways:
EV/EBITDA is usually a better measure of valuation when a company has debt.
If Net Income and EBITDA are too far apart, it requires further investigation
Adjust the Adjusted EBITDA: Look at the items under adjusted EBITDA. Deduct stock based compensation if it has been added back. Look at the one-time items under adjusted EBITDA - should these really be adjusted?
Calculate your own or use EBITDA (not adjusted)
Look at past yearly numbers. If EBITDA is increasing but Operating Cash Flow is not, or they are going in opposite directions. This is a major red flag. It means the company is not expensing items the way they should.
I hope I’ve given you a good sense on why EBITDA is still a valid number to use, how to use it, how to adjust for it and why it’s not all that evil after all.
If you have any questions, please feel free to drop a comment.