Falling in love with EBITDA

I was asked recently why EBITDA is increasingly the standard way of measuring and reporting company profits, especially when it concerns valuations and transactions. You rarely hear of companies being bought for a price multiple of net profits, for example, but often of a multiple of EBITDA.

There are two reasons: EBITDA measures the company’s operational performance and it is the measure of profit that is closest to the company’s cash flow. Let me explain.

The P&L has three sections, each with a different role.

1The first calculates the Gross Margin by subtracting the Cost of Goods Sold (the cost of producing the product or service) from the revenue. Gross Margin measures the company’s value-add and some companies don’t bother reporting revenues at all. If Uber, for example, makes $2 from a $10 ride or $2 from a $20 ride, it’s the GM of $2 which is the key figure (and in fact, Uber only reports its GM, not its revenue).

Investors like high margin businesses because of the value-add and generally, higher GM businesses will have higher valuations. Entrepreneurs and M&A boutiques tend to think of valuations in terms of revenue multiples, but that’s not the way investors value businesses.

2The second part of the P&L measures operational efficiency by subtracting overhead costs from GM to produce EBITDA. Overheads are either analysed by activity — sales & marketing, research & development, general & administrative — or by type: staff, office, travel etc. While COGS are variable (doubling revenue will double COGS), overheads are fixed (office rent does not change if sales increase). Well, that’s the theory. In practice, overheads are at best semi-variable, because if sales double, the company may need larger offices, for instance. A company is described as scalable if overheads do not move much with sales, and investors like scalable businesses.

3The third part of the P&L is about how companies are financed. Investors and owners decide whether to use equity and or debt and in what proportion. If there is debt, profits are reduced because of the interest charge, even though the company has not done anything differently from an operational perspective. EBITDA removes that anomaly.

The depreciation of fixed assets and the amortization of intangible assets such as acquired intellectual property or companies are excluded because they are considered to be part of the investment in the company: what is needed to produce the profit in the first place. And because these items are non-cash, meaning the cash balances of the company are neither increased nor reduced by depreciation and amortization expenses, it brings EBITDA closer to real cash flow. (Simplistically, cash flow = EBITDA + Δ Working Capital + Δ Equity Capital + Δ Fixed Assets).

Net Profit, as it includes interest costs but not dividend payments, can in fact be pretty much irrelevant in understanding a company’s valuation.

Here’s the summary: