Q: What is Ebitda?
A: Earnings before interest, tax, depreciation and amortisation. It's the metric-du-jour for company performance and valuation. Investment bankers start corridor conversations with 'It's trading on 6 times Ebitda'. The French magazine L'Expansion just ran an editorial touting Ebitda as the new cure-all for the dot.com and TMT valuation bubbles - no more revenue multiples or dollars-per-eyeball (as with all things Anglo-Saxon, the French are a bit behind the curve).
Q: Why is it now in favour?
A: It's a sort of proxy for operating cashflow. Start with after-tax profit. Add back interest and tax, to exclude the effects of gearing and tax management. Then add back depreciation and amortisation charges - on the basis that these reflect historical investment decisions (like a factory re-fit three years ago, or old R&D), rather than current cashflow.
A good thing about Ebitda is that it's clearly a lot better than dot.com-era revenue multiples, which were really stupid. A bad thing about Ebitda is that, as an absolute measure of value or target for business performance, it's still stupid, although not as stupid as revenue multiples.
Q: Why is Ebitda stupid?
A: I don't mind adding back depreciation and amortisation if I then deduct current-year cash capital spend - what the business is actually paying out this year on new factory re-fits, R&D etc. That gets me to RGOOCF - Real good old operating cash flow. This is what I'm hoping will grow at 15% a year and pay dividends in my old age.
Q: Isn't that rather obvious?
A: It is a truth universally acknowledged that managers manage to optimise that which is measured - particularly where their own short-term performance-related pay is involved. If I'm a CEO with bonus and option grants tied to Ebitda, and the analysts are valuing my stock on Ebitda multiples, I'll manage around Ebitda. If I'm cynical, I'll throw money at 'assets', at cap ex and R&D - anything that I can capitalise and charge over the next five to 10 years. And I'll re-classify as much operating expense as possible as cap ex so I can spread it into the future - like IT expenditure. The accounting standards boards and tax authorities help here: they want me to capitalise my IT spend and pay more tax earlier.
I've just been looking at a retail business that's up for sale. The owners want to talk Ebitda, which has been going up nicely. But cash cap ex spend on new shops, shop re-fits and IT has been going up a lot faster - RGOOCF has plateau'd and is now declining. That cap ex is a normal annual operating cash cost for the business. I know what I'm basing my valuation on, and it isn't Ebitda.
Q: What's this to do with diets?
A: Ninety per cent of diets fail. They have no scientific basis. The only way to sustained weight loss is Eat-a-bit-less-and-exercise-more. But .. there's a new diet fad every year (low fat, high protein, low carb, high carb), a bottomless appetite for diet books and an endless search for the simple-fix killer diet.
The search for the one-line killer metric of company performance and value is similar. We stopped liking absolute earnings in the 1970s and switched to earnings-per-share (EPS), to stop conglomerates diluting shareholder value with stupid acquisitions. But then, whoops, it didn't stop them throwing money at low-return assets to grow EPS.
We liked market value/book value for a while, until along came software and intellectual capital businesses without any book value. We liked EVA, because it made businesses think about return on investment - but then the EVA-ers started talking in terms of 'absolute dollar' EVA, which is incomprehensible. (Revenue multiples were like a Survive-on-carrot-juice diet or Live-on- McDonald's-and-lose-weight.)
Q: So are these metrics - and diets - no use at all?
A: Diets get people thinking about how much they eat, so can help trigger a change in lifestyle. Similarly, even inadequate metrics like Ebitda help managers and analysts focus on company performance and value. They're a big step in the right direction, but there's no substitute for the complex, no-shortcut path of analysing and generating RGOOCF, just as there's no quick-fix way around Eating-a-bit-less-and-exercising-more.
Now if you'll excuse me, I'm off to start my red-wine-with-full-fat-cheese diet (and I've just seen this great stock trading at only six times Ebitda).