Methods and concepts for Value Based Management (VBM)
EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, came into wide use among private capital firms calculating what to pay for a business .
The private capital firms that originally employed EBITDA as a useful valuation tool removed interest, taxes, depreciation, and amortization from their earnings calculations in order to replace them with their own presumably more precise numbers:
- They removed Taxes and Interest because they wanted to substitute their own tax-rate calculations and the financing costs they expected under a new capital structure.
- Amortization was excluded because it measured the cost of intangible assets acquired in some earlier period, including goodwill, rather than any current expenditure of cash.
- Depreciation, an indirect and backward-looking measure of capital expenditure, was excluded and replaced with an estimate of future capital expenditure.
Later, many public companies, analysts and journalists have urged investors to also use EBITDA as a measure of the cash public companies generate . EB7I7TDA is often compared to cash flow because it rightfully adds back to net income two major expense categories that have no impact on cash: depreciation and amortization.
Financial Value Cash Flow Traditional Income Measure (Residual Income Component)
Yet EBITDA is a very poor and even misleading mechanism if it is used to approximate cash flows of public companies! Why?
- It excludes taxes and interest, which are real cash items and not at all optional—a company must obviously pay its taxes and loans.
- On the other hand, it does not exclude all non-cash items, only depreciation and amortization. Among the non-cash items not adjusted for in EBITDA are bad-debt allowances, inventory write-downs, and the cost of stock options granted.
- Unlike proper measures of cash flow, EBITDA ignores changes in working capital. Additional investments in working capital consume cash.
- Finally, the main flaw of EBITDA is in the E (Earnings). If a public company has over- or under-reserved for warranty costs, restructuring expenses, or bad-debt allowances, its earnings will be skewed and its EBITDA misleading. If it has recognized revenue prematurely or disguised ordinary costs as capital investments, its numbers are suspect. If it has inflated revenue through round- trip asset trades, the E is of no informational value.