I could not let the subject of EBITDA off the hook until I took a couple of more minutes to explain the “EBITDA Trap”. What is the EBITDA Trap? It’s when you value and pay for a company based on EBIDTA (or Gross Cash Flow) but only earn Free Cash Flow. For instance, a company has an EBITDA of $1MM and you decide to pay 4X EBITDA or $4MM. Congratulations, you have made a deal and best of luck it’s all good from here on in.
However, you find that the cash generated from the business is not $1MM – that was the EBITDA and so you start to have some doubts. So what happened? Remember from the last post that EBITDA was shorthand for Gross Cash Flow. You need capital equipment of $100,000. Oh yeah, you have interest payments of $210,000 (say you borrowed $3MM @ 7%). By the way what about taxes? (Say 40% of $1MM less interest deduction of $210,000) which is $320,000. So your Free Cash Flow is equal to $1MM – $100,000 – $210,000 – $320,000 or $370,000!!!!!!!!!!!!!!
This is a close approximation of what really occurs aside from the nuances of some tax issues. The TRAP is that acquirer’s value and acquire Gross Cash Flow but in return generate Free Cash Flow. This example does not even that into account the notion of principal payments on the borrowings. Consider the implications – on a Free Cash Flow basis you may have paid 10.8X Free Cash Flow – or 11 years worth of cash flow. And you thought you were paying 4X.
Chew on that for a bit and next posting we’ll work through how not to get trapped.