A fellow contributor recently wrote an article highlighting the many shortfalls of using EBITDA (earnings before interest, taxes, depreciation, and amortization) for securities analysis. While the article provided a very insightful look into the many shortfalls of EBITDA, I disagree with the author's conclusion not to use EBITDA for analytical purposes. In fact, I believe that EBITDA can be a very useful analytical and valuation tool, when used properly.
A Flawed Metric Used By Many
Undeniably, EBITDA ignores a number of important factors; not least of which being Capex (capital expenditures) and interest expense, which can consume a substantial portion of a company's cash flow. Despite these obvious shortfalls, EBITDA remains one of several primary metrics used for the analysis and valuation of companies and their securities.
Take a look at security research reports (particularly for corporate bonds, but also for equities), bank loan and bond covenant statements, credit rating agency reports, or even the key statistics for companies on websites like Yahoo! Finance and you'll find that EBITDA is one of the key metrics used for analysis. While such widespread use, in and of itself, is no justification for the use EBITDA, it does beg the question: Why are so many analysts using EBITDA, despite its clear limitations?
A skeptic would say that it's because companies and their investment bankers have pushed EBITDA, as it flatters results. While there may be some truth to that theory, I believe that it underestimates the collective aptitude of the analyst community (particularly the very skeptical analysts of the high-yield bond community, who use EBITDA as a primary metric for credit analysis).
In my opinion, the real answer to the question lies in context. No valuation metric is useful when used in isolation; however, EBITDA is rarely used in such a manner.
Typically, EBITDA is used relative to metrics that incorporate debt or related interest expenses (e.g. Enterprise Value/EBITDA, Net Debt/EBITDA, and EBITDA/Interest). Secondly, these EBITDA ratios are typically used for comparative purposes across an industry where relative on-going capital expenditure requirements are similar (i.e. the companies generally spend a comparable amount of Capex relative to EBITDA).
As such, debt and resultant interest expenses are captured in the ratios, while the impact of the Capex omission is broadly consistent across the different companies. While such comparisons are NOT appropriate across industries with vastly differing Capex needs, they can be very useful for comparisons within one particular industry.
EBITDA is often also used relative to debt or interest and actual Capex levels (e.g. [EBITDA - Capex]/Interest). These ratios are more useful for the comparison of companies across differing industries with different capital expenditure requirements.
When using these EBITDA multiples that incorporate Capex, the EBITDA ratios can actually be more relevant than net income ratios. This is because these EBITDA ratios reflects actual Capex levels, while net income ratios reflects depreciation and amortization - backwards-looking data that reflects the accounting treatment of previous spending for Capex and investments.
As a result, depreciation and amortization expenses (and their resultant impact on net income) can be totally disconnected from economic reality by vastly over or understating these expenses relative to a company's actual ongoing capital expenditures and investment requirements.
In securities analysis, there are too many variables to consider for any one metric to ever capture everything. All metrics have limitations and need to be looked at within the context of many additional factors. Even actual cash flow (and operating cash flow less Capex) can be misleading, if there are substantial non-recurring items that are impacting the results.
For the above reasons, individual financial metrics (and ratios) should only be a starting point for analysis. Comprehensive securities analysis should always incorporate a full examination of ALL of the financial statements, with a focus on normalized ongoing cash flow.
All that said, I believe that EBITDA ratios (adjusted for non-recurring items and in proper context) can be very useful metrics for quick and simple screenings. This is particularly true for the comparison and analysis of early-stage and/or highly-leveraged companies that have yet to generate net income (e.g. for high-yield corporate bond analysis).
The bottom line is that EBITDA is used by the analyst community for good reasons. As such, it probably always will be one of several primary tools used for the analysis of companies and their securities.