Limitations of EBITDA as a Meaningful Financial Metric

Understanding EBITDA applications is crucial to accurate buyout values.

This analysis examines EBIDTA as an overused metric that does not represent real economic profit.  According to the author, eight subtractions are required to consistently and accurately determine true profit values.  

In the financial reporting and analytical world, more reference and reliance to the EBITDA metric has been seen—EBBADABADOO, as some industry jokesters call it.  EBITDA is short for “earnings before interest, taxes, depreciation and amortization”, and is a non-GAAP (generally accepted accounting practice) metric, really a subtotal to the income statement.  It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA was popularized as a credit metric, used in the 1980s M&A and credit analysis world to test for adequacy of debt coverage.  The most common leverage ratio uses total debt or long-term debt to EBITDA as a ratio: the higher the ratio, the higher the debt and the more risky; the lower the ratio, the more debt that might be piled on.  In my area of focus, the restaurant space for example, a one to three times debt-to-EBITDA factor might be okay, but above six or seven is risky.

EBITDA is often the common denominator to track and report company buyout values.  The acquisition enterprise-value-to-EBITDA ratio is a very commonly reported metric. In fact, it’s so common, that’s where the focus goes. When used as a simple business valuation tool, the company is worth some multiple of EBITDA:  the higher the multiple, the higher the price and vice versa.

Not surprisingly, EBITDA is now showing up as a proxy for discussing GAAP earnings in some earnings calls.  Let’s look at Wendy’s (WEN) or Burger King (BKW) as an example. They highlight and report the EBITDA change from year to year and provide an EBITDA value in guidance.  Perhaps their logic is, if the actual earnings dollars or earnings per share are light; better to talk a bigger number.  A company might have no or negative earnings, but positive EBITDA.

EBITDA is also showing up in the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section. The special problem there is EBITDA is stated in terms of the restaurant-level profit only—before overhead.

Really, the problem is this: EBITDA doesn’t show the whole picture.  It is a subtotal.  It doesn’t show full costing. Warren Buffet’s partner, Charlie Munger, opined EBITDA is “earnings before everything.” 

Stern Stewart and Company was onto something in the late 1980s when they created the EVA methodology or “economic value added” profit.  EVA, their proprietary calculation, subtracted the total cost of capital from the operating profit that the capital produced to arrive at economic profit.  EVA thus became a more sophisticated value creation measurement. That seems rather logical, but more difficult to define and implement. All businesses give higher visibility to the profit and loss (P&L).  Everyone gets the concept of revenue less expenses equals profit, but what about the balance sheet?  Where is the cash or asset value and where did it go?

In a capital or R&D intensive business, where a lot of fixed assets are in use, or if a large business purchase is to be amortized, EBITDA alone as the metric misses at least eight costs and expenses.  These are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.

Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted and listed in order of magnitude of the cash outlay to really get to economic profit:

1. Interest expense: The cost of the debt must be calculated. Interest is amount borrowed times the interest rate, times the number of years.  Is it positive or negative?  One can have rising EBITDA, but still go broke.
2. Principal repayment:  The business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a five or seven-year maturity note and is another very large cost that must be considered.
3. Future year’s major renovation/remodeling: Once the storefront is built, it has to be renewed and refreshed on a regular cycle, often every five to ten years, via capital expenditures (CAPEX). That often is 10-30 percent of the total initial investment or more, over time.
4. Taxes—state and federal: Financial analysis is often done on a pre-tax basis, as there are so many complicating factors. The reality is the marginal tax rate is about 40 percent.
5. New technology and business mandates: Aside from the existing storefront that must be maintained, new technology and new business innovation, CAPEX must be funded to remain competitive.  Example: new POS systems for restaurants or new technology for hotels.
6. Overhead: If the EBITDA value is stated in terms of a business subcomponent like a store, restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Usually, there are no cash registers in the back office and it is a cost center.
7. Maintenance CAPEX: For customer-facing businesses (retailers, restaurants and especially hotels), some renovation of the customer areas and storefront must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows; you get the idea. In the restaurant space, a good number might be two percent of sales.
8. New expansion must be covered by the EBITDA generation, to some level:  New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion. 

You might say, these other costs and expenses are common sense. They should show up in the detailed cash flow models that should be constructed or they can be pro-rata allocated, but how many times does this really happen? The EBITDA metric becomes like a book title, or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood. The saying is true; whatever you think you see in EBITDA…you need more.

John A. Gordon, MAFF is a restaurant analyst.  His firm, Pacific Management Consulting Group (www.pacificmanagementconsultinggroup.com), provides complex financial and operational analysis and advisory services concentrated on the restaurant sector. He works expert engagements for both plaintiffs and defendants, and is reachable via (619) 379-5561 or jgordon@pacificmanagementconsultinggroup.com.