Cogito

Problems with EBITDA

Posted in CFA by qmarks on May 5, 2010

Lately I have been discussing about the price multiples, such as P/E, P/Sales, P/Book value. There is one widely accepted multiple named EV/EBITDA which is simply the Total Enterprise Value over Earnings Before Interest Tax Depreciation and Amortization. Although EV/EBITDA is preferred to P/E multiples, EBITDA in nature has some problems too.

Factors that are ignored in EBITDA do have a material effect on a company’s cash flows. For example, the EBITDA calculation ignores changes in working capital, investing cash flows such as capital expenditures and asset sale proceeds, and financing cash flows such as proceeds from the issuance of equity, dividends, and loan payments. Also, EBITDA will provide a misleading measure of cash flow for companies that require significant and recurring investments in fixed assets.

In addition, EBITDA, like other earnings and cash flow measures, can be manipulated by adjusting a company’s revenue and expense recognition policies. For companies which exhibit stable working capital requirements, EBITDA can be a useful estimate of operating cash flow, as well as for total cash flow if investing and financing cash activities are relatively small. EBITDA’s wide acceptance as a measure of operating performance and cash flow makes it useful, but it is important to understand its limitations. If you require an accurate measure of a company’s operating cash flow or totatl cash flow, you may have to disregard its EBITDA and focus on the measures of operating cash flow and total cash flow reported in its Statement of Cash Flows.

It is good to remember those issues when we compare EV/EBITDA multiples across companies.

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