A Clear Look At EBITDA

Normally, investors focus on cash flow, net income and revenue as the basic measures of corporate health and value. But in recent years, another measure has crept into quarterly reports and accounts: earnings before interest, taxes, depreciation and amortization (EBITDA). While EBITDA can be used to analyze and compare profitability between companies and industries, investors should understand that there are serious limits to what the metric can tell them about a company. Here we look at why this measure has become so popular and why, in many cases, it should be treated with caution.

EBITDA is a measure of profits. While there is no legal requirement, according to generally accepted accounting principles (GAAP), for companies to disclose EBITDA, it can be worked out and reported using information found in a company's financial statements.

The earnings, tax and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT), and then add back depreciation and amortization.

EBITDA Rationale
EBITDA first came to prominence in the mid-1980s as leveraged buyout investors examined distressed companies that needed financial restructuring. They used EBITDA to calculate quickly whether these companies could pay back the interest on these financed deals.

Leveraged buyout bankers promoted EBITDA as a tool to determine whether a company could service its debt in the near term, say over a year or two. At least in theory, looking at the company's EBITDA-to-interest coverage ratio would give investors a sense of whether a company could meet the heavier interest payments it would face after restructuring. For instance, bankers might argue that a company with EBITDA of $5 million and interest charges of $2.5 million had interest coverage of 2 - more than enough to pay off debt.

The use of EBITDA has since spread to a wide range of businesses. Its proponents argue that EBITDA offers a clearer reflection of operations by stripping out expenses that can obscure how the company is really performing.

Interest, which is largely a function of management's choice of financing, is ignored. Taxes are left out because they can vary widely depending on acquisitions and losses in prior years; this variation can distort net income. Finally, EBITDA removes the arbitrary and subjective judgments that can go into calculating depreciation and amortization, such as useful lives, residual values and various depreciation methods.

By eliminating these items, EBITDA makes it easier to compare the financial health of various companies. It is also useful for evaluating firms with different capital structures, tax rates and depreciation policies. At the same time, EBITDA gives investors a sense of how much money a young or restructured company might generate before it has to hand over payments to creditors and the taxman.

All the same, one of the biggest reasons for EBITDA's popularity is that it shows more profit than just operating profits. It has become the metric of choice for highly leveraged companies in capital-intensive industries such as cable and telecommunications, where bona fide profits are sometimes hard to come by. A company can make its financial picture more attractive by touting its EBITDA performance, shifting investors' attention away from high debt levels and unsightly expenses against earnings.

Be Careful
While EBITDA may be a widely accepted indicator of performance, using it as a single measure of earnings or cash flow can be very misleading. In the absence of other considerations, EBITDA provides an incomplete and dangerous picture of financial health. Here are four good reasons to be wary of EBITDA:

1. No Substitute for Cash Flow
Some analysts and journalists urge investors to use EBITDA as a measure of cash flow. This advice is illogical and hazardous for investors: for starters, taxation and interest are real cash items and, therefore, they're not at all optional. A company that does not pay its government taxes or service its loans will not stay in business for long.

Unlike proper measures of cash flow, EBITDA ignores changes in working capital, the cash needed to cover day-to-day operations. This is most problematic in cases of fast-growing companies, which require increased investment in receivables and inventory to convert their growth into sales. Those working capital investments consume cash, but they are neglected by EBITDA.

For example, Emergis, an information technology solutions company, highlighted $28.4 million EBITDA for the fiscal year 2005. But if you turn to the company's cash flow statement, you'll see that it consumed $48.8 million in additional working capital, which largely accounts for Emergis' negative cash flow from operations. Clearly, EBITDA paints a rosier financial picture than other measures.

Furthermore, while capital expenditures are a critical, ongoing cash outlay for almost every company, EBITDA neglects capital expenditures. Consider US LEC, a small communications service provider. In its Q4 2005 earnings release, the company reported $14.3 million EBITDA. That represents a 30% improvement from Q4 2004, when it reported EBITDA of $11 million. But this measure disregards the company's sky-high capital expenditures. Looking at US LEC's 8-K filing, we see that the company spent $46.9 million on network capital equipment in Q4 2005; in order to grow, it will need to continue spending annually to upgrade and expand its networks. This number is significant, but it is not part of the EBITDA mix.

Clearly, EBITDA does not take all of the aspects of business into account, and by ignoring important cash items, EBITDA actually overstates cash flow. Even if a company just breaks even on an EBITDA basis, it will not generate enough cash to replace the basic capital assets used in the business. Treating EBITDA as a substitute for cash flow can be dangerous because it gives investors incomplete information about cash expenses. If you want to know the cash from operations, just flip to the company's cash flow statement.

2. Skews Interest Coverage
EBITDA can easily make a company look like it has more money to make interest payments. Consider a company with $10 million in operating profits and $15 million in interest charges. By adding back depreciation and amortization expenses of $8 million, the company suddenly has EBITDA of $18 million and appears to have enough money to cover its interest payments.

Depreciation and amortization are added back based on the flawed assumption that these expenses are avoidable. Even though depreciation and amortization are non-cash items, they can't be postponed indefinitely. Equipment inevitably wears out, and funds will be needed to replace or upgrade it.

3. Ignores Quality of Earnings
While subtracting interest payments, tax charges, depreciation and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from interest, taxation, depreciation and amortization, the earnings figure in EBITDA is still unreliable.

Let's say, for example, that a company has over- or under-reserved for warranty cost, bad debt or restructuring expenses. If this is the case, its earnings will be skewed and, as a result, EBITDA will be misleading. Furthermore, if the company has recognized revenues prematurely or disguised ordinary costs as capital investments, EBITDA will provide little information to investors. Remember, EBITDA is only as reliable as the earnings that go into it.

4. Makes Companies Look Cheaper Than They Really Are
Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples. Consider the wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn't mean the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much higher 20 times. The company traded at 48 times its estimated net income. Investors need to consider other price multiples besides EBITDA when assessing a company's value.

Conclusion
Despite its widespread use, EBITDA isn't defined in GAAP - as a result, companies can report EBITDA as they wish. The problem with doing this is that EBITDA doesn't give a complete picture of a company's performance. In many cases, investors may be better off avoiding EBITDA or using it in conjunction with other, more meaningful metrics.

EV: Enterprise Value

The enterprise value - or EV for short - is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focus on its current market capitalization. It measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a clearer picture of real value with EV than with market capitalization.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

The Calculation
Simply put, EV is the sum of a company's market cap and its net debt. To compute the EV, first calculate the company's market cap, add total debt (including long and short-term debt reported in the balance sheet), and subtract cash and investments (also reported in the balance sheet).

Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 shares and each share currently sells for $25, the market capitalization is $250. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company's value, market cap simply represents the company's price tag.

The Role of Debt and Cash
Why are debt and cash considered in valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions price is typically set higher than the market price) and must also repay the firm's debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted from the firm's price as represented by market cap.

Think of two companies that have equal market caps. One has no debt on its balance sheet while the other one is debt heavy. The debt-laden company will be making interest payments on debt over the years. (Preferred stock and convertibles that pay interest should also be considered debt for purposes of calculating value.) So, even though the two companies have equal market caps, the company with debt is worth more.

By the same token, imagine two companies with equal market caps of $250 and no debt. One has negligible cash and cash equivalents on hand, and the other has $250 in cash. If you bought the first company for $250, you will have a company worth, presumably, $250. But if you bought the second company for $500, it would have cost you just $250, since you instantly get $250 in cash.

If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay a lot more than $250 if he or she were to buy the company's entire stock. The buyer has to assume $150 in debt, which brings the total acquisition price to $400. Long-term debt serves effectively to increase the value of a company, making any assessments that take only the stock into account preliminary at best.

Cash and short-term investments, by contrast, have the opposite effect. They decrease the effective price an acquirer has to pay. Let's say a company with a market cap of $25 has $5 of cash in the bank. Although an acquirer would still need to fork out $25 to get the equity, it would immediately recoup $5 from the cash reserve, making the effective price only $20.

Ratio Matters
Frankly, knowing a company's EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company's cash flow or EBIT. Comparative ratios demonstrate nicely how EV works better than market cap for assessing companies with differing debt or cash levels or, in other words, differing capital structures.

It is important to use EBIT - earnings before interest and tax - in the comparative ratio because EV assumes that, upon the acquisition of a company, its acquirer immediately pays debt and consumes cash, not accounting for interest costs or interest income. Even better is free cash flow, which helps avoid other accounting distortions.

For a good example, go back to 2003 and look at the price of two comparable stocks: Sears and JC Penney. At $45 per share, Sears had a market cap of $13.5 billion and P/E (market cap/earnings) ratio of 10. But its balance sheet was burdened with nearly $30 billion in net debt. So Sears' EV was $43.5 billion, or about 14 its $3.4 billion in EBIT.

By contrast, JC Penney enjoyed a share price of $23 per share and a market cap of $6.1 billion and P/E ratio of 20, twice that of Sears. But because JC Penney owed a lot less - its net debt stood at $3.5 billion, its EV was $9.6 billion and its EV/EBIT ratio was only 10, compared to Sears' EV/EBIT of 14.

By market cap (P/E) alone, Sears looked like it was half the price of JC Penney. But on the basis of EV, which takes into account important things like debt and cash levels, JC Penney was priced much less per share. As the market gradually discovered, JC Penney represented a better buy, offering more value for its price.

Conclusion
The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.