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EBITDA: Some Things to Consider

John Kielich, CPA   email | bio 
Managing Director of Kolb+Co. M&A Advisers
June 2010

As an adviser on merger and acquisition (M&A) transactions, I am acutely aware of how many buyers, sellers and advisers rely on Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) for determining the fair price of a transaction. That said, throughout my training and sixteen years as the head of corporate development, I have found that EBITDA is not the basis for the value of a target nor a supported technique on valuation projects. Yet it is discussed and used often in the M&A world.

EBITDA is most helpful when used to convert a price to a common reference point for the parties involved in a transaction. As a buyer it gives you a gauge for the pricing of current deals. As a seller it gives you a point of reference for the offer you might get. For an M&A adviser it provides a good starting point for when your client asks, "How much am I worth?" or "How much should I expect to pay?" In addition, there is a wealth of information published on deal pricing as a multiple of EBITDA. So, why not use EBITDA?

I will start with my basic bias that a buyer needs to base a price on the present value of the projected free cash flow of the business. Certainly the application of this method is not without its challenges, but it is based on what I think should be most critical to a buyer, cash flow. It is cash that pays off the cost of an acquisition, and, while EBITDA has been used often as a substitute for cash flow, it is not always perfect.

First consider the add-back for depreciation within the EBITDA calculation. This is a non-cash item, and, in theory, it does belong as an add-back to earnings in order to produce cash flow from operations. However, buyers need to ask two questions:

1. How much is needed in capital expenditures to support the business?
2. Has the business either deferred the acquisition of needed fixed assets or are there additional expenditures that are needed to grow the top line of the company?

If the answer to either question is yes, then the cash outlay needs to be considered in the projections. These capital expenditures are real cash and are not apparent when only considering EBITDA.

In addition to capital expenditures, working capital is another area that is often overlooked. I define working capital as accounts receivable, plus inventory, minus accounts payable. Simply using EBITDA as a substitute for cash flow has a built-in assumption that working capital stays the same. This is often not the case particularly if there are assumptions that include increasing revenue. In many instances the increase in revenue is only achieved by having a higher level of accounts receivable and inventory. This is another use of cash that needs to be considered in the analysis.

I could also argue the need to include taxes in your analysis of what a company is really worth. It is very likely that we will see an increase in tax rates both at a corporate and an individual level. As a result, the amount of discretionary cash available to service debt in the future will decrease regardless of the structure of the entity.

It is all about cash. Cash is what sellers want and what buyers need to acquire companies and ultimately pay loans back to the banks. EBITDA is not always the same as cash, so be careful. I have a Microsoft Excel tool that uses the concept of free cash flow for estimating a price. To receive the spreadsheet, please email me at jkielich@KolbCo.com.