The Problems with Using EBITDA as a Measure of Cash Flow
An analysis of how to appropriately measure a company's cash flow generation and the reasons why EBITDA is not the answer.
5 minutes
Thesis
Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”), is analytically flawed and a wrong measure of a company’s cash-generating ability because it ignores depreciation, which is a real expense, as fixed assets must be maintained and replaced. It is not hard to understand that plant and equipment wear out from normal business use, and companies must make capital expenditures to maintain their competitive position.
Historical Context
Understanding the origins of EBITDA sheds light on why it is a flawed proxy for a company’s cash-generating ability. The use of EBITDA rose in popularity in the 1980s, when investors in securities started using free cash flow as the analytical measure of value. At this same time, the market was experiencing a strong bull run from the rise of zero-coupon bonds and the junk bond frenzy. In their efforts to justify higher and higher valuations, investors replaced free cash flow with EBITDA, a simpler number, that would quantify a company’s cash-generating ability.
Example
As an example of why using EBITDA as a measure of a company’s cash-generating ability is wrong, consider the following two businesses.
Which business is worth more?
Investors relying on EBITDA as their only analytical tool would value these two businesses equally. However, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing. Although these businesses have identical EBITDA, they are not equally valuable. Company X could be a low capital-intensive service business that owns no depreciable assets and generates a significant amount of free cash flow. Company Y could be a manufacturing business in a competitive industry.
So, what is the correct way to evaluate a company’s cash-generating ability?
Investors can start their evaluation of free cash flow with net operating profit after taxes. This is the amount of cash flow that a business can generate. NOPAT is a useful measure because it separates a business from the effects of its capital structure, which can be influenced by management.
A company can over or under estimate depreciation, as a result, it is important to subtract net investment or disinvestment in fixed assets of a business (depreciation and amortization - maintain capital expenditures) from NOPAT.
Finally, investors should also consider changes in non-cash working capital. An increase in non-cash working capital means that more cash is being tied up in the business, this represents an outflow of cashflow.
For example, consider a company that increases its inventory, these assets represent cash that is being tied up and will only generate a return after they are sold.
Furthermore, a decrease in non-cash working capital means that less capital is being tied up. This can occur if a company reduces its current assets or increases its credit with suppliers. A company can benefit from having credit from suppliers because it means that suppliers finance their inventory from the time the company receives it to when they have to pay it.
Cash is excluded because it generates a fair market return. Net interest-bearing liabilities are also excluded from the calculation because this debt is considered when computing the cost of capital and it would be inappropriate to count it twice.
Our end calculation for free cash flow to the firm looks like this:
FCFF = EBIT (1- tax rate) + Depreciation - Capital Expenditures - Changes in Non-Cash Working Capital.
Great insight!