Why even use EBITDA?
Why is EBITDA such a common metric in the industry to refer to a company's valuation or profitability? I understand the rationale that it ignores capital structure and tax differences allowing you to compare companies based on their operations. However, as an equity investor, you care about your after-tax returns, you don't put EBITDA in your pocket.
For example:
* 2 companies with $10m EBITDA
* If you slap a 5x multiple on them they are both worth $50m
* Company A has little capex and low tax rate, while company B has high capex and high tax rate
Knowing this, you would receive more levered free cash flow from company A even though they would be valued the same with an EBITDA multiple. My question is, why don't more investors use levered free cash flow to value investments? You can just assume you buy both companies with x% debt and then see what LFCF you would get the first year in operations with the new cap structure and value-based off that.
No one actually just says “EBITDA is x so the Company is worth Y” it’s just useful as a standard metric that allows you to pretty reasonably compare companies with different capital structures pretty quickly (especially companies with similar business models). Your problem with looking post-tax is now you’ve added capital structure considerations, given effective tax is largely the result of choices in cap structure.
High capex businesses trade for less than low capex businesses generally so that’s how people account for that.
EBITDA is like any metric - useless without context.
Makes sense and what I was expecting. Just have seen the term EBITDA referenced to what investments were trading at while rarely hearing about cash flows so wanted to ask. Since multiples are too broad to value a business from, do you simply rely on financial models based on assumptions and a target IRR
Yeah the key here is that EBITDA is really just metric that provides a reasonable-ish approximation for cash flow across most industries. So for taking a quick glance at a company vs. its industry peers or looking at relative valuation levels for industries it’s useful.
However if you were actually looking to make an investment - you would use EBITDA multiples only for the sake of checking the market if this was a competitor process. You’d model out cash flows for the sake of seeing what returns you’d earn at various purchase prices. Just because the market says companies in industry X trade at 10x, if the cash flows don’t justify it, you wouldn’t do it.
Having been interning in IB this summer and seeing models that project cash flows up to 30 years, I want to ask why don’t people value a business based on an entry multiple instead of an IRR at a certain price. My thinking being that projections are almost never right in a model since no one knows the future, especially the longer the time period. Would it not be better to see if 1) it’s a good industry; 2) it’s a good business with potential; and 3) you are entering at a low price (multiple of cash flow). Instead of doing the npv of cash flows or price at a certain IRR
You're learning to ask the right questions my friend. Us hedge fund guys tend to grow a bit of cynicism for bankers for the simple reason that they are always trying to sell something (duh- that's their job). Nothing personal. If IRR makes the Company look more valuable then it's IRR. If EV/EBITDA is the most "attractive" versus comps then it will be featured. Offshore drillers? Look how "cheap" they are on price to book. None of these metrics fit (like Tech today)...start making up new metrics! 30 year projections are a joke and anyone who is investing money (PE, HF, Corp Biz Dev, etc.) hopefully knows this. Garbage in, garbage out as they say. No offense to you but how much thought (or potential thought) can really go into the growth rate between 2027-2030? You probably just want to finish the model and get some sleep! None of this is to take away from the banking skillset that you are learning..but keep asking those questions and think practically and think about how the processes you're being taught may differ from what you'd want to do as an investor. One of the biggest advantages to going through junior banking if you don't stay in the business long term is that understanding of "how the sausage is made" behind the scenes.
OP- looks like you got some good answers. Bit of a nitpick but remember that EV/EBITDA is indeed a measure of "cash flow." The type that you are describing is "free cash flow." I can tell you with distressed credit investor hat on, the reason we sometimes like EV/EBITDA is that it can tell you the cash flow potential of a business while remaining fairly cap structure agnostic. At the end of the day, I will choose how to capitalize the business so want an unbiased sense of cash flows. Similar to growth capital investment (though we'll often consider an EBITDA - maintenance capex number).
I started my buyside career in value investing (post banking) and we would literally screen for companies that were under 6x LTM EBITDA to source ideas. This is Exhibit A1 of how NOT to use EBITDA. You know what we ended up owning? A bunch of value trap cigarette butts...
Any one valuation metric should be in context (+1 Banking Sucks Guy) and multiple valuation metrics should be used to triangulate.
Adding on to other excellent comments in this thread:
Things like capital intensity, cyclicality, tax rate, etc., should be reflected in the multiple you put on EBITDA. All else equal (assuming returns on capital are similar, similar industry/end markets, etc.), a biz with higher capital intensity deserves a lower EBITDA multiple than a comp with lower capital intensity due to inferior FCF conversion.
This gets a bit more complicated if we think the returns on capital for those capex investments will be high: if we expect nice returns on that investment then we will want the company to make those investments, lowering FCF now but improving growth prospects and thus garnering a higher multiple on current EBITDA/FCF to reflect those growth prospects.
You are on to something with your question though. The E&P industry is an excellent example of the shortcomings of EBITDA (or EBITDAX, an E&P specific metric that excludes exploration costs). Plenty of investors have gotten burned by investing in E&Ps which look cheap based on multiples on EBITDA, but these 'earnings' never seem to turn into cash.
Can someone explain why it’s so important to look at earnings without taking into account capital structure?
To get a true idea of the 'earnings power' of the business. Net income / free cash flow include interest expense and the resulting tax shield. You could have a very high quality business whose profits are eaten up by interest expense, leaving them with minimal net income / free cash flow. if you compare that company to a similar peer that has no debt and whose earnings flow down into net income / free cash flow (as they are not paying interest expense, although this is partly offset by a higher tax rate), looking at EBITDA will tell you a different story than net income / free cash flow.
Because we’re going to put our own capital structure on the business. I don’t care what the prior owners elected to do in terms of capital structure because I’m going to wipe the whole thing out and put brand new equity/debt into the business. Therefore all I need to know is the EBITDA and I can layer in my own assumptions on equity / debt required to fund the deal and operate the company under our ownership. This makes EBITDA a much “cleaner” number as it is based on the ongoing operations and will be the starting point for the new investor.
What rugbyladdy said is also completely valid.
What do you think of "EBITDA - Maintenance CapEx"? That also excludes cap structure decisions, fiscal choices etc
Capital structure is a non operating decision that can change in the pro forma business. Say a company is taken private through an LBO. The capital structure changes. The ebitda multiple is a way to look at a business though operating decisions.
This may sound like a cheeky answer but: You make it up. There is no “right” multiple. One looks at all of the different factors — growth potential, risks such as customer / supplier concentrations, stability of earnings, stability of the industry, and 1000 other factors. As you analyze these, you make a judgment call on what the appropriate multiple to pay.
Modeling can serve as a guideline as well. The model makes assumptions about future cash flows, exit multiple, capital structure, etc., then ultimately spits out a projected IRR if all the assumptions come true. If the IRR is below your return threshold, you can lower your EBITDA multiple (and therefore purchase price) to bring pricing in line with your investment parameters.
Think of it this way: There is no fixed multiple (or price) for a private company because the future is unknown. Each investor will look at the company differently. Generally, the investor with the most conviction is willing to pay the highest price and is probably going to win the auction (if the company is being marketed to a bunch of buyers). Determining the appropriate EBITDA multiple is very much an art form and, in practice, as much about gut feel and experience as it is about metrics and models.
Wouldn’t you be able to look at a database of precedent transactions based on sic or naics codes for the LMM to determine a multiple?
all helpful answers. just wanted to add an real estate analogy to Banking Sucks Guys' comment. when you value an apartment EBITDA is like the size of the place, or the square footage. Size is relevant to the value of that place but it's not the whole story. Square footage doesn't inform you on the location or whether the place has in-unit washer and dryer, factors that influence the price significantly too. How do you know one place is more expensive than the other? You can calculate "price per sqft". which is like the EBITDA multiple, to gauge the price relative to peers.
Why EBITDA vs. levered free cash flow? to compare companies using levered free cash flow, you have to make so many more assumption on cap structure (why the same? each company may have different or even varying cap structure over time) and capex (part of capex is discretionary meaning it will fuel growth but it's okay not to invest. so it's not exactly "little" vs. "more" capex. This is complicating things.
Anyone, specifically Europeans (?), who use EBITA? I’ve interned and worked for two different banks and a lot of the MDs insisted on looking at EBITA. Pain in the ass tbh.
Not my area of expertise, but could it feasibly be due to differences between IFRS and GAAP reporting and what is capitalized vs. what isn't?
Unlevered fcf is what you would want to see. Ebitda is quick and easy to calculate where as with cash flow, things can start to get a little tricky. The idea is to have a number you can compare across capital structures. Levered fcf depends on your choice of cap structure and as such really can’t be used as a standard metric. Would love to see unlevered fcf used more but considering bankers run processes, it’ll never happen
lg
Another associated question which I wasn't able to find an answer to from my office colleagues. When calculating an EV / EBITDA multiple, EBITDA is usually taken on an LTM basis but the more popular P / E multiple is based on NTM earnings. Is this simply based on convention or is there a solid reason for this?
This can go either way (LTM vs. NTM). The street generally spends more time modeling EPS over EBITDA, so that may be why (EPS estimates are probably marginally more reliable than EBITDA estimates).
As far as sell-side processes in my experience in MM banking, multiples are almost always based on expected EBITDA for that year. Depends on where you are in the year though as we sometimes try to sell off the following year. That's when everyone's favorite CIP slides and highlights come into play - "high visibility", "recurring", "revenue in the bag by Q1", etc.
This all relates to private co transactions typically to MM PE firms so maybe a bit different than how valuation would work for a large MF take-private, but I wouldn't know. And also totally depends on the type of business so don't want to make too large a generalization..
Your profile says you work in PE, and as far as I know, EV/EBTIDA is the more popular one there by far. When I was working on transactions, I didn't look too much at P/E multiples as a PE would have a different capital structure anyway. But, to answer your question, I tend to prefer a LTM number as I don't need to make any assumptions on growth (it is what it is). However, LTM P/E are more affected by one off items and various other adjustments. So, if I used EBTIDA, I would look at both LTM and NTM, but preferred LTM. But with P/E, NTM was a more standardized number than LTM (and LTMs for comps were a bit all over the place at times).
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