The Right Profit!

As it’s July I should be talking about strawberries and Wimbledon, but instead I want to talk EBITDA!

EBITDA (Earnings Before Interest Tax Depreciation and Amortisation) is the most commonly used valuation metric – and chosen primarily as a proxy for free cash flow – but is it the right measure when valuing a business?

One of our clients recently pointed us to a Warren Buffett video, and he commented “Not thinking about Depreciation as an expense though, strikes us as absolutely crazy.”

Indeed, the same client also did a quick analysis on recent acquisitions, and broadly speaking all the acquired businesses depreciation went up after acquisition.

We recommend that when using EBITDA you also deduct the anticipated capital expenditure – to get the true cashflow, but I can see why our acquirers prefer to look at EBIT or even Profit After Tax (PAT) when thinking about earnings multiples. And Depreciation is clearly a reasonable proxy for annual capital expenditure in most businesses.

Now strictly speaking it doesn’t matter what earnings or revenue multiple you look at – in the end it comes down to the actual price paid, but does the use of EBITDA encourage us to ignore the ongoing capital expenses in the business?

Clearly EBITDA being the most used metric, gives us comparability between deals, and we’ll continue to use it – but it pays to never forget that Depreciation (and tax and interest) are real expenses.