Dear Thank you for sharing this important question.

Initially, I agree that EBITDA is an instrument to auxilary in the process of analyzing the profitability of the organization. However, I think it cannot be taken as something definitive, in isolation. One of the reasons is exactly the same as you put at the end of the question: the fact of not expressing the cash flows correctly. Greetings!

Thanks for your intuitive feedback

Dear Richard

The EBITDA measures the ability of an entity to generate profits taking into account only the productive activity of the business. It is a financial indicator that I like to use in the financial analysis of a company's income statement because it represents the flow obtained from the operating activities developed by an firm regardless of the company's financial structure and taxes. In other words, it is a good indicator to know if the core business is healthy, or if, on the contrary, it suffers from deficiencies.

However, it is important to keep in mind that EBITDA is not an accurate indicator to analyze in terms of generating cash flow, even though calculations of provisions, amortizations and depreciations are excluded, no other items that are included represent outflows of money, such as financial payments or sales and purchases that have not yet been made effective, as well as extraordinary results like non-recurring income items and expenses .

Hope this will help you.

Dear Richard

The EBITDA should capture most of the operating cash flow measure of the firm and is derived entirely from the income statement without having to collect data from other financial statements such as the balance sheet. Comparing the EBITDA to other similar firms as well as over time (trend analysis) for the same firm would give a consistent unbiased metric. However, if you suspect the company has some operating cash flow issues and question their solvency then including items such as discretionary accruals would improve the analysis. I suggest some literature:

Article The Valuation of Cash Flow Forecasts: An Empirical Analysis

Article An Empirical Analysis of Analysts’ Cash Flow Forecasts

https://onlinelibrary.wiley.com/doi/full/10.1111/j.1745-6622.2001.tb00430.x

http://heinonline.org/HOL/Page?handle=hein.journals/cmlrv12&div=29&g_sent=1&casa_token=&collection=journals

Article The Association Between Various Earnings and Cash Flow Measu...

Perhaps the article in this link below could add something of value/interest connected to your question. Best regards Bo Nordlund

https://www.brec.se/wp-content/uploads/2016/05/BN-EPRA-News-March-2014-FCFF.pdf

Dear Richard,

As a former practitioner in the international debt capital markets, I can tell you that EBITDA is widely used as a measure of a firm's ability to both carry and pay for debt. It is also used by the major credit rating agencies as a key account item metric in their determination of long-term probability of default (credit rating scale equivalents) particularly in conjunction with other measures such as EV (Enterprise Value). Therefore it is used as a 'relative' value metric, but not for 'absolute' value. However, market practitioners, especially those investing in stocks & bonds typically place more emphasis on relative rather than absolute equity valuation. Hope this adds to the other constructive comments.

It's my understanding that EBITDA valuation was invented by investment bankers to extract a higher valuation for weak companies as opposed to analysts or portfolio managers attempting to calibrate their price targets. I'm not saying that makes it a bad metric, but consider the source.

EBITDA is based on p/l, and even if depreciation/amortization, there are still oupstanding trade debtors in revenue and accruals in the costs, so not necessarily actual cash flows. and approximity cash depends then on industry sector (AR/AP rotation cycles). Also, as such still subject to (accounting) policy choice.

EBITDA in the U.S. is a non-Generally Accepted Accounting Principles (GAAP) term. Please see the U.S. Securities and Exchange Commission's ASR 142 dealing with non-GAAP terms. Some years ago certain financial analysts were looking for a way to show value, which was not there. They indicated if an entity had a net loss, putting a P/E multiplier on that loss would only exacerbate the size of the loss. Hence, there would be little chance of successfully marketing such an entity's debt or securities. However, if interest, taxes, depreciation, and amortization expenses were added back to net income (EBITDA), there would be a positive number to which a P/E multiplier could be applied with positive results. The genesis of EBITDA. Personally, every time I hear the term EBITDA used as a value metric, the hair on the back of my neck stands up. So beware of the value of EBITDA.

A couple of comments on top of some very good answers before. First, there is not a single measure of valuation that could be taken as a "perfect measure or model". So, each measure or even model has pros and cons. Second, EBITDA is usually an input to relative measure valuation indicators as the EV/EBITDA measure.

This relative value measure is extensively used in different contexts. It is used by the sell side (analysts and investment bankers), as part of their toolbox of measures, and specially for international comparisons of companies where differences in terms of depreciation or amortization practices, taxation and so on may distort bottom line measures. But it is clear that (as any other measure) is only a partial view of the reality of a company or a peer group of companies. For instance, EBITDA is not a proper measure for some sectors (banking or financial services as a prime example), and EBITDA is obviously unable to detect differences in debt service (even companies with the same level of leverage may be facing different financing mixes and prices). It is also used under the same principles (international comparison) for buy side analysts and investors (portfolio managers).

But EBITDA, and the EV/EBITDA ratio, is also extensively used for private equity managers transaction valuation (as a first, rule of thumb, quick valuation number). Obviously, no private equity firm will enter a transaction without a full valuation analysis, due dilligence and a lot of analysis and paperstuff. That said, private equity managers usually employ this measure as a shortcut for initial analysis and assesment of the opportunity.

Best!

Carlos

EBITDA (EBIT + Depreciation and Amortization, EBITDA) is a proxy, it is an incomplete version of FCF or any other CFs (you can arrive to FCF, to CFE and to CCF starting from EBITDA). What is of interest for valuation is the Free Cash Flow, FCF or the Capital Cash Flow CCF or the Cash Flow to Equity CFE or the FCF + Tax Savings (when using the APV approach for valuation).

In summary, if you need to value a firm, don't use EBITDA, use the proper cashflow (ALL methods, if properly done, will yield the same and identical result: the firm value (in the case of CFE you need to add the value of debt).

In addition, multiples are not a "method" for valuation. Use multiples AFTER you have done a proper and detailed valuation. Having value, you can COMPARE with multiples for the industry. Say, you divide your calculated Value through EBITDA, EBIT, Net Income, Sales, whatever..., and compare that with the average for the industry or with a recently transaction for a firm belonging to the same industry.

Best regards

Ignacio

In my opinion, the Indicator EBITDA (Earning Before Interest, Tax, Depreciation and Amortization) is not an economic increase, or profit. The amortization ratio with the long-term assets is not an efficiency indicator of the long-term assets. It (EBITDA) also is not the plethora money because included the pre-paid money in the long-term assets . Thus, this indicator (EBITDA) is not important by terms of economic effect.

Dear Richard

EBIT or EBITDA (depending on the case) is a righteous performance indicator from both an academic and practitioner stance. On the latter, This metric purposefully isolates taxes, interests, depreciation, and amortization which might fluctuate depending on special circumstances, i.e., due to differences in taxation and interests Multinational Companies (Kelloggs, Unilever)use it for fair comparisons of performance for their branches in different countries.

Also, companies might use different depreciation systems making it difficult to compare. Thus EBIT or EBITDA isolates these effects.

Regards

Oscar

Some brief comments in addition to the answers above:

As mentioned before, EBITDA on its own is not sufficient for valuation. It is used as part of a multiple valuation (e.g. EV/EBITDA) in practice, although this leads to only a rough estimate of company value. For DCF valuation EBITDA is not enough. Depending upon the DCF approach used (APV, WACC, FTE) either unlevered FCF or levered FCF are to be discounted. EBITDA measures only part of the FCF (unlevered or levered).

If I may add the link to a paper of mine:

Article A Tool Kit for Discounted Cash Flow Valuation: Consistent an...

EBTI is the significant financial indicator of one, but I think that EBITDA is not even indicator of operating or financial risk and, nor financial effect of company. Although dynamics of the Depreciation and amortization indicators characterize to tempo of the circulation of the value of long-term assets.

Consider the following:

Period Receipt Issues Balance Price FIFO LIFO

3 100,000 75,000 25,000 20 1,500,000 1,500,000

4 60,000 75,000 10,000 24 1,940,000 1,740,000

5 80,000 75,000 15,000 26 1,930,000 1,950,000

6 90,000 75,000 30,000 28 2,070,000 2,100,000

7,440,000 7,290,000

Sales 18,900,000 18,900,000

COGS ( 7,440,000) ( 7,290,000)

Gross Profit 11,460,000 11,610,000

Selling & Admin Expenses ( 6,000,000) ( 6,000,000)

EBITDA 5,460,000 5,610,000

Depreciation ( 700,000) ( 700,000)

EBIT 4,760,000 4,910,000

Interest ( 500,000) ( 500,000)

EBT 4,260,000 4,410,000

Taxes ( 1,704,000) ( 1,764,000)

EAT 2,556,000 2,646,000

Clearly you can see that the method of inventory valuation has a distorting effect on the cash flow. So at best using EBITDA to determine cash flow will not lead to an exact answer.

Audley Eccles

I would suggest you to read only one article given below, it gives complete answer to your question.

Article Title : Warning: Use of EBITDA may be dangerous to your career

https://heinonline.org/HOL/LandingPage?handle=hein.journals/cmlrv12&div=29&id=&page=

I still think that the cost of the amortization is equal to the element of material and labor costs. For profitability of operating activities Income should cover all these expenses.

The process of production can not be made without the use of fixed assets. Therefore, the indicator of profit is not exist before deducting amortization.

EBITDA can be construed as measure of the entrepreneurial abilities of the managers based on controllable costs since matters such as depreciation, interest expenses and taxes can be beyond managers' discretion in short-term. I am not quite sure whether EBITDA has any impact on cash flows especially where direct method of statement of cash flows is adopted.

Comment to Brian Phiri Kampanje

EBITDA is "almost" equal to FCF. It is the starting point to arrive to FCF (or CFE) using an indirect method (EBITDA chg in WC - taxes, etc.). The indirect and direct method, if properly done, should arrive to the same FCF or CFE. Hence, EBITDA or Net Income as starting points to arrive indirectly to FCF and/or CFE, obviously have an impact on cash flows....

Of course, EBITDA and Net Income have impact on the indirect method for deriving cashflows and on the statement of cash flows.

In addition, ALL valuation methods (APV, CCF, FCF, CFE, using the appropriate discount rates) yield (should yield) THE SAME value of firm and equity. If not, something is wrong. You can see this example (bilingual): http://cashflow88.com/decisiones/ejemplo_paso_a_paso.xlsx where I show that to my students. Notice there that you have the final results and in the center a space to fill it with the proper formulated cells. Also, you find there a sheet where you can see the proper formulas for the cost of capital (Ke and WACC) under different assumptions of the discount rate for the Tax Shields.

Dear Prof. Wamalwa,

By Modigliani Miller Theorem stock market prices should not depend on DCFs only but overall profit which is more appropriately measured by Funds Flow measures like Funds from Operations. However, Depreciation Allowance should not be adjusted in measuring P/E ratio say, because it is certainly a part of the rental cost of operations, the bigger the asset size the higher the DA, hence the change in the value of equity of any specific company should depend on this size effect and get reflected in price fluctuations. We have estimated a DGE model of India's Emerging Stock Markets over time and industries by using this definition of profit and concept of stock market DGE pricing dynamics. This has given us R^2 as high as 0.77 over ten year panel data with over 50 companies for "blue chip" companies i.e. those companies on the Bombay Stock Exchange with P/E ratio of over 10. We have run our regressions using PAT but included Interest Cost on the r.h.s. along with it as a separate variable that way we have added back the IC can be said. The estimated coefficients on IC are significantly different from that on PAT from our test of heteroskedasticity. Hence, it is proved that PAT and IC behave in different ways so far as DGE pricing in Stock Markets are concerned. (Mallick, Sarkar, Roy, Duttachaudhuri & Chakraborty (2007)) on www.researchgate.net/profiles/Soumitra_Mallick, and there is some reasons behind your claims that EBIDTA is a superfluous measure but not entirely justified.

Soumitra K. Mallick

No. Just a practical measure.

Good answer Emmanuel.

I think in all the above discussion the concept of EBITDA measurement with respect to valuation is well explained. I think EBITDA is most suitable to use in management accounting to judge the operating performance of a manufacturing firm for decision-making purposes. We are must be aware of the calculation of EBITDA which is behavioral and may suffer from a revenue recognition problem which may lead to represent higher or lower value EBITDA particularly in contractual businesses.

EBITDA is profit before deduction of profit tax, interest and depreciation. That is, it is operating income less operating expenses and increased depreciation. That is, this ratio is free from the impact on the value of long-term assets. Thus, in my opinion EBITDA can be used to comparatively characterize trends in operating results (management skills) of different companies.