Why only EBITDA?

September 25, 2017

by a searcher from Massachusetts Institute of Technology - MIT Sloan School of Management in Miami Beach, FL, USA

EBITDA dominates discussions of valuation in the search fund world Both the Stanford Search Fund Primer and the HBR Guide to Buying a Small Business say that we should value businesses (with adjustments, of course) as 3x - 5x EBITDA. However, I can't stop thinking about Charlie Munger's feelings on this popular metric: "Every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

I can see why EBITDA might be a reasonable measure for a business that isn't asset heavy and isn't highly leveraged. And I would bet that your typical search fund acquisition target isn't asset heavy (lots of light industry and service firms) and isn't highly leveraged (well, at least not until the search fund owns the company).

So, I don't agree with Munger on EBITDA earnings being bullshit earnings in the context of searchers. But I don't think EBITDA is the be-all-end-all measure to conduct valuation. It seems dangerous to rely on a single measure, if only that it might cause a searcher to inadvertently overlook other financial problems because she is distracted by a great EBITDA number.

Why not also throw operating profit and net income into the mix? For discussions with sellers and investors, focusing on a single metric should make the discussion clearer. For internal analysis, I believe searchers should absolutely be considering other profitability measures to make sure they're not getting suckered into a bad deal.

What are your thoughts on EBITDA, oh good people of Searchfunder?

Reply by an investor
from Boston College in Steamboat Springs, CO 80487, USA

EBITDA is a pretty good preliminary filter, but what you actually build the deal on is a financial model projecting net cash flows from your operating profit, financing costs, capital expenditure, inventory, taxes and so on. Free cash flow is probably a more pure metric to base your search on, but the important part is understanding the limitations of whatever data you're able to get from the broker / seller and work from there. The key limitation with EBITDA is that the deduction for depreciation and amortization is not free and doesn't reflect future required capital expenditure. The reason they're removed is because depreciation schedules can be quite far from the reality on the ground so an ad hoc adjustment for capital and inventory costs is often necessary.

Reply by a searcher
from Universidade Federal de Minas Gerais in R. Eng. Zoroastro Tôrres - Santo Antônio, Belo Horizonte - MG, Brazil

I would argue that EBITDA is a good measure of the operational performance of the company. In addition to this, it easier to communicate and to use as a reference for discussion with brokers and sellers. The net income has more noise into it. In our case, I am using EBITDA as a first check but also considering other relevant metrics, such as operating ratios and FCF.

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