As noted in our previous exploration cash flow is the touch stone of valuation methodologies, and business in general.
EBITDA is widely used in practice as a convenient “proxy” for cash, and no journey into valuation would be complete without a deep dive into this concept. EBITDA will be explored regarding what it represents and how it is determined. Once fully understood, owners can use EBITDA to obtain an indication of company value and value creation. Its use in practice and criticisms of EBITDA will also be explored as our journey continues.
EBITDA is derived from a firm’s income statement, starting with net income and adding back non-cash items such as depreciation and amortization. Interest expense and income taxes are added back to neutralize the impact of debt and tax structures. This makes comparison of various firms possible without regard to debt or tax structures of various companies. The goal of calculating EBITDA is to determine the operating cash flow available for investment in the firm, pay-down of debt, or other payments such as dividends/distributions to owners.
EBITDA is one factor (variable) in the Classical Multiple of EBITDA Model to determine an implied business firm value. We turn to the other factor (variable) in our discussion of multiples.
EBITDA is generated by the operating results of the firm, which are generally within the control of the firms’ managers and owners. As such, EBITDA is a measure of the efficiency, effectiveness, and efficacy of the firm’s management/leadership.
Caution: EBITDA as proxy for operating cash flow is not without critics. We will explore the main criticisms in due course.
EBITDA is often used as a convenient and useful proxy for operating cash flow. To be used properly, it must be fully understood by the user.