Why do portfolio managers use EBITDA as a valuation metric?

[beerbaron]

I was listening to a portfolio manager the other day and he was using EBITDA as one of it's main valuation metric. I just can't understand why a person would take away the interest and the depreciation into a valuation. These are important components...

 

Depreciation, even if not a cash charge is still very real and, except in rare cases, will cost cash one day or another.

Interest is a cash charge and it's usually one of the most senior cash expense. After all the management could slash all their workforce, terminate their lease but the company would still have to pay the interests.

 

I can only see two cases where EBITDA could be somewhat used as a valuation metric:

-If a company is really short on cash. And it is a valuable metric only if the fact of being short on cash is temporary. Or else it seems to me like keeping a zombie alive.

-If the depreciations are actually lower then the maintenance CapEx

 

So why do people paid at evaluating companies take out the most optimists assumptions to make their calculations???

 

BeerBaron

[ExpectedValue]

If you are comparing firms, EBITDA is a helpful metric because you are getting a more neutral picture, especially if two firms are using different methods of depreciation.

 

Plus, if you are using enterprise value, then it makes sense to add back in the interest charge because to do enterprise value you're already adding back in the debt. That's why it usually is EV/EBITDA and P/E, not EV/Net Income.

 

I don't hone in on any 1 metric, I look at EV/EBITDA (or EBITDAR), P/E, EV/FCF, P/FCF when comparing between different companies.

[rmitz]

I was listening to a portfolio manager the other day and he was using EBITDA as one of it's main valuation metric. I just can't understand why a person would take away the interest and the depreciation into a valuation. These are important components...

 

Depreciation, even if not a cash charge is still very real and, except in rare cases, will cost cash one day or another.

Interest is a cash charge and it's usually one of the most senior cash expense. After all the management could slash all their workforce, terminate their lease but the company would still have to pay the interests.

 

I can only see two cases where EBITDA could be somewhat used as a valuation metric:

-If a company is really short on cash. And it is a valuable metric only if the fact of being short on cash is temporary. Or else it seems to me like keeping a zombie alive.

-If the depreciations are actually lower then the maintenance CapEx

 

So why do people paid at evaluating companies take out the most optimists assumptions to make their calculations???

 

BeerBaron

 

Of the above factors, I think Depreciation is the hardest one to work out.  All the others really can be quantified very easily as cash values, but depreciation can be difficult; it is usually better tax-wise to try to depreciate aggressively, but then you may have assets down the road carried at basically nothing which are still providing value. In addition, the replacement costs may be either higher or lower than the original investment, sometimes dramatically, due to changes in the underlying business and/or technology.

[finetrader]

concerning depreciation..

 

many company will use different depreciation method:

 

an aggressive rate for tax purposes

an a less aggressive rate in the income statement so that they can show higher earnings to investors.

 

[Myth465]

I think these things only look difficult if you are thinking about things quantitatively. Once you start to see things from a qualitative perspective the picture becomes clearer. Depreciation is a quite simple concept, and fairly easy to get your hands around if you A - know the business, B - know what part of the cycle you are in, C - know the capex spend over the last cycle and the plan for this one.

 

Some invest throughout the cycle, some counter cyclically (similar to SSW), and some with the cycle. I tend to think about the business then subtract out what I think is maintenance capex. If the Manager is allocating capital properly then growth capex should take care of itself and raise IV, if not then why are you even looking at the company?

 

With that said I have still been burned a few times this year so what do I know.

 

I pretty much only use FCF, and EV. I dont really use EBITDA, because I dont tend to use relative value much. Either its cheap and the capital structure makes sense or not. EBITDA is a nice short hand though, its typically always quoted and one can easily reverse engineer it to get what they want.

[Guest Bronco]

I'd be rich if I didn't have to pay interest and taxes.

 

But I'm broke.

 

 

[beerbaron]

I'd be rich if I didn't have to pay interest and taxes.

 

But I'm broke.

 

Or if your car never needed any maintenance... Just make sure the gas tank is not empty and your ready for 1 billion miles.

 

BeerBaron

[Baoxiaodao]

I used to have the same question as I think it does not makes sense, even though I know it makes sense quantitively. Now I adopt the method to calculate intrinsic value only. It helps me a lot in overcoming my hesitance to invest in excellent businesses while the price is a bit high.

 

I was listening to a portfolio manager the other day and he was using EBITDA as one of it's main valuation metric. I just can't understand why a person would take away the interest and the depreciation into a valuation. These are important components...

 

Depreciation, even if not a cash charge is still very real and, except in rare cases, will cost cash one day or another.

Interest is a cash charge and it's usually one of the most senior cash expense. After all the management could slash all their workforce, terminate their lease but the company would still have to pay the interests.

 

I can only see two cases where EBITDA could be somewhat used as a valuation metric:

-If a company is really short on cash. And it is a valuable metric only if the fact of being short on cash is temporary. Or else it seems to me like keeping a zombie alive.

-If the depreciations are actually lower then the maintenance CapEx

 

So why do people paid at evaluating companies take out the most optimists assumptions to make their calculations???

 

BeerBaron

[Partner24]

In my book, it's a kind "let put some pink glasses" valuation metric.

 

Banker: hey, you didn't paid your interest on your debt this month.

Boss: Oh, but the consultant told me to not pay attention to interest when I valued the businesses. So, I do not have to pay you, right?

 

Government: hey, pay your corporate taxes or your business is bankrupt.

Boss: so, businesses have to pay taxes too?! Are you kidding me?

 

Employee: Boss, our equipment is scrap. If you don't buy new one soon, we'll not have anything to sell.

Boss: Oh, I tought it wasn't needed to replace it eventually....

Employee:...

Boss:...

Employee: Did the consultant told you that our salary wasn't a real expense neither?