Analysts Love This Metric. Here’s Why You Shouldn’t.

October 6, 2017

Analysts Love This Metric. Here’s Why You Shouldn’t.

  • EV/EBITDA is a widely used metric these days, so every investor should understand what it is.
  • We’ll discuss how EV/EBITDA is calculated and how you can manipulate it.
  • There are some pros to using it, but also some cons.



Introduction

When I was just starting with investing, I remember that the beta coefficient was popping up everywhere, next to almost every stock price or price to earnings ratio.

The beta coefficient has faded in the last two decades as it was clear that markets aren’t efficient and that there is no real usage of the metric. Now a new metric has emerged lately and is used by most analysts.

A recent scientific survey from Jerald E. Pinto from the CFA Institute found that 92% of analysts use a market multiple approach followed by other approaches.

Figure 1: Most used metrics by financial analysts. Source: SSRN.

Of those who use a market multiple valuation, the most used is of course the price to earnings ratio followed by the EV/EBITDA metric with 76% of respondents using it.

Figure 2: Most used market multiple metrics by financial analysts. Source: SSRN.

So the second most used metric is the EV to EBITDA metric.

In today’s article, we’ll discuss the pros and cons of the metric so you can better understand what managements or analysts are talking about when flashing fancy numbers and comparing stocks to buy.

Let’s start with what EV/EBITDA is and how to calculate it.

What Is EV To EBITDA?

Let’s first discuss EV.

Enterprise Value – EV

EV stands for enterprise value.

Figure 3: EV definition and calculation method.

Here is an example of the calculation of Apple’s EV.

Figure 4: Apple’s EV calculation. Source: Author’s calculation based on Apple’s financial statements.

NOTE: For those who immediately checked data providers on Apple’s EV, the difference mostly comes from the fact that I deducted long term marketable securities from EV as most of Apple’s long term marketable securities are bonds that can be exchanged for cash immediately. Also, I take all liabilities while some would not take payables and other non-interest-bearing liabilities into consideration. Nevertheless, this points to the first weakness of the metric, calculation is arbitrary.

The point is that if you want to acquire Apple, you would have to pay $724 million as you have to pay the owners for the market price, the debt holders (option), and you can take the cash out once you own the company.



Earnings Before Interest, Taxes, Depreciation & Amortization – EBITDA

In order to calculate EBITDA, you have to add interest, taxes, depreciation, and amortization to net income.

Figure 5: Apple’s EBITDA calculation. Source: Morningstar.

So what you’re doing is almost doubling earnings by eliminating factors such as taxes, interest expenses, and depreciation. The rationale behind EBITDA promoters is that it shows how the business is actually doing as the removed expenses can obscure actual business performance.

Interest depends on the management’s choice of financing, taxes vary all the time due to possible previous losses, and depreciation can be subjective. For example, you can depreciate a building but it actually doesn’t lose value over time.

So Apple’s EV to EBITDA is 9.69, which is below the analysts’ rule of thumb of 10, and is usually considered a good investment.

The EV/EBITDA Pros & Cons

The issue is that if you give bonuses to management based on EBITDA, they can quickly focus on increasing EBITDA and not on increasing shareholder value. If interest rates don’t matter, then a manager is enticed to take debt that has marginal profitability just to increase short term EBITDA.

For example, a company with market capitalization of $1 billion, no debt, and EBITDA of $50 million has a EV/EBITDA ratio of 20. A manager can take $500 million in debt at an 8% interest rate and invest it in a business that has a 10% temporary EBITDA yield, thus a risky business. After a year, the company’s EBITDA is now $100 million with a EV of $1.5 billion. The new EV to EBITDA ratio is 15 which, according to the current financial environment, would be regarded as a job well done and the stock price would probably appreciate back to EV/EBITDA 20 again as most analysts follow the metric.

However, let’s take a look at earnings. At a 30% tax rate and no interest cost, and assuming no depreciation, the company’s earnings would be $33 million before the loan. Afterward, the company has $500 million more in debt, additional interest costs of $40 million per year, and increase EBITDA of $50 million. Thus, the total increase in pre-tax income is only $10 million, or $7 million after tax. That’s a 21% increase in net income, but beware of the $500 million in debt. As soon as something in the environment changes, the company is on its way to bankruptcy.

The point is that such metrics really incentivize expensive acquisitions that rarely create value. No wonder EBITDA and EV/EBITDA were coined in the 1980s in the leveraged buyout era.

Big banks are incentivized to keep using EBITDA as it allows for more acquisitions due to the higher perceivable income coming from the elimination of taxes, interest rates, and depreciation. As big banks get high fees from merger and acquisition activity, they will continue to promote and use EBITDA. The bigger the acquisitions, the higher the fees are.

Removing depreciation and taxes is just a way to make the business look better. A company that has to invest lots of cash into new equipment will have high depreciation rates and, consequently, high EBITDA but low or perhaps even negative earnings.

Taxes can’t be avoided, so there is no logic in removing them from valuation metrics only to make the company look better.



Therefore, all metrics that skew performance and can manipulate investors’ perception should be highly questioned before being used.

On top of everything, the EV/EBITDA is highly volatile as are EBITDA and market capitalization. Thus, another thing to be careful of.

I’ve summarized the current and the 5 year average EV/EBITDA, 5 year average earnings, and dividend of three miners to show how such metrics change all the time and at one point, one company is better than the other and vice versa.

Figure 6: Financial metric comparison for Rio Tinto, BHP Billiton, and Norilsk Nickel. Source: Morningstar.

I’ll conclude by saying that an investor, not a speculator, should focus on the value of the stock calculated by the present value of future available cash distributions to owners and compare that value to the price of the stock. If the returns are satisfying on a personal level, then the stock is a buy.

All of those metrics that use volatile past data, skewed earnings, and can easily be manipulated by management should be left to analysts and Wall Street investment bankers. Unfortunately, those metrics didn’t ruin them as we have been bailing them out for the past 8 years and will probably do it again next time as that’s how this world works.

For those who don’t believe it, below is a chart from Goldman that shows how monetary policies in the last 8 years have benefited those who own assets and those who work for their salaries.

Figure 7: Asset values continue to inflate while wages just barely beat inflation. Source: Goldman Sachs.

Now, I’ll conclude this article by letting better investors than I discuss the cons of EBITDA-based measures.



What Do Buffett & Munger Think About It?

The metric is used so much despite the fact that investors like Buffett and Munger constantly speak out against it. They even discussed it thoroughly at the last Berkshire shareholder meeting.

Buffett has said that depreciation is an expense and the worst kind of an expense. This is because with depreciation, you spend the money first and record the expense later. Buffet continues by describing EBITDA as a mass delusion but he understands the logic behind it as by eliminating some expenses, valuations become higher which is in the interest of Wall Street, especially if you are paid from the amount you manage, not on your performance. It seems EV/EBITDA is a misleading statistic that can be used in pernicious ways.

Munger goes even further and defines those who have created the term as disgusting in nature because it isn’t honorable behavior to use EBITDA. It’s just flashing double the earnings than what they actually are.

To quote Munger, “Nobody is in the right mind who thinks depreciation is not an expense.” Munger wraps things up by saying that the usage of EBITDA in business schools is horror squared, and that it is bad enough that a bunch of thieves use the term, but even worse when business schools copy it.