A flawed method

Aug 10, 2017
As a method of valuation, EBITDA does not have credibility – despite its seeming favour with the press and others.

In the 1990s, the US press – seeking sophisticated financial shorthand for reporting on large-scale acquisitions or mergers – began the practice of dividing the total acquisition price by the latest published earnings before interest, taxation, depreciation and amortisation (EBITDA) of the acquired company, thereby producing a multiple of EBITDA. At the time, investment analysts regularly produced EBITDA for all quoted companies as a means of comparison within particular business sectors – a practice that continues today.

In theory, EBITDA strips out the distortions between companies in the same sector; distortions caused by different policies on depreciation, different tax regimes (meaning across different countries), the fact that some companies use borrowings more than others, and so on. The idea is to get to the core profitability of the business and allow like-for-like comparisons between different businesses operating in the same sector. When used in that context, EBITDA makes sense.

However, EBITDA in effect started a reverse process in valuation as the multiple of EBITDA was calculated after the acquisition or merger. This process of historical analysis then acquired a status the other way around in both the US and UK, meaning that a multiple of EBITDA devolved into a method of valuation by investment advisers for the assessment of potential sales or acquisitions in the first place.

An inexact science

The valuation of businesses and shares is not an exact science. The basic concept of valuation is that it is the right to receive future income – meaning net-of-tax profits or dividends – which is being valued. Within that fundamental concept, there are accepted precepts that enable most valuations to fall within a range. It is the judgement of the valuer or the market price for a quoted company which determines the valuation within that range.

From time-to-time, there is an attempt to take away or diminish the precepts and judgement aspects of valuation and instead introduce some mathematical or analysis-based process to produce the answer. One such example is a valuation based on discounted cash flows (DCF) which, on closer analysis, has so many variable inputs that it is effectively meaningless and could provide almost any answer to suit the circumstances of the valuation. Similarly, the writer has been offered computer programs that claim to provide valuations by simply typing in a few figures.

Sometimes the suspicion is that complex wording or an apparently sophisticated formula is used to justify a particular transaction. The monies, and the related fees, in investment banking are vast. However, authoritative studies in the UK and US have repeatedly shown that a majority of large-scale acquisitions have proved disappointing and overpriced to their new owners. There have been many complete failures. Obviously, the price paid for the acquisition was based on somebody, somewhere, making a valuation and then persuading others as to its validity. Time and again, it has been later demonstrated that nobody could properly explain how the acquisition was valued in the first place.

Fundamentally flawed

In this context, in the writer’s view, the promotion and use of EBITDA as a method of valuation is fundamentally flawed. For example, a heavily-borrowed company is treated as equal to a company that has little or no borrowings. Similarly, a company with depreciation on relatively non-productive or aged assets is treated the same as a similar company with depreciation on highly productive or newer assets. Interest and depreciation are real and often substantial costs, and it makes no sense to exclude them in assessing the future profits of a company. It makes even less sense to apply a valuation multiple to an outcome that excludes these costs. Excluding amortisation is sensible, though, as it is an accounting requirement that is ultimately irrelevant to the trading of the business.

EBITDA has limited uses for high-level sectoral analysis. As a method of valuation, however, it does not have credibility. None of the leading UK text books on valuation support it as a method of valuation; nor does any academic study known to the writer. Warren Buffet, the legendary investor, has referred to EBITDA valuations as “fraudulent” and “useful to the tooth fairy”. Nevertheless, EBITDA valuations are still presented as a knowledgeable and sophisticated method of valuation and are often reported as such in the financial press.

A recent Irish Supreme Court judgement referred extensively to EBITDA in a dispute involving a valuation: Donegal Investment Group plc vs Danbywiske, Wilson & Others.

Des Peelo is author of The Valuation of Businesses and Shares, published by Chartered Accountants Ireland.