MacGladrey Capital Markets LLC just completed an excellent report on the state of M&A. I was just about to summarize their findings when I realized that I should take a step back. In almost every discussion of valuation EBITDA is mentioned. Buy why EBITDA? Why not the Net Income of a company as a means to value a company? Because EBITDA is shorthand for gross cash flow. And when you are acquiring a company you are buying cash flow – the amount of cash that the entity will generate. Actually, you are buying FREE cash flow, but companies are typically valued on GROSS cash flow or EBITDA. We’ll explore FREE cash flow on our next turn at understanding financial metrics.
EBITDA defined is Earnings before Interest Taxes Depreciation and Amortization. But why use this measure of earnings? Because it normalizes cash flow, for instance;
- Interest is excluded because companies are capitalized differently. For example if you acquired a company for $5MM and borrowed $4MM the interest carrying costs would be much greater than if you paid all cash or stock for that matter. Additionally, companies have different costs of capital – or pay differing interest rates. Some companies borrow money to operate while the same company may choose not to borrow. Nonetheless they may produce the same amount of cash flow prior to an interest deduction.
- Taxes are excluded because companies have different legal structures. For example, a partnership or LLC pays taxes at the partnership level. As such no taxes appear on the financial statements of the COMPANY. On the other hand a company formed as a corporation pays taxes at the corporate level. Hence, taxes appear as an expense line item in the financial statements.
- Depreciation and Amortization are non cash items that appear on the financial statements. For accounting purposes depreciation is calculated as follows; 1) company buys equipment for $1MM 2) the equipment has a useful life of five years 3) the equipment is expensed over a period of five years 4) the expense on the books of the company is $200,000 per year EVEN THOUGH the company paid $1MM in year one. So in reality the $200,000 of expense in years 2 thru 5 is only an accounting adjustment – hence it’s added back (no cash expended).
Next post we will discuss the pitfalls of valuing a company on EBITDA alone. And provide some concrete examples of EBITDA calculations.