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Calculated risks

By Roger Armstrong

Tuesday 1st July 2003

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Market watchers have become increasingly sophisticated over the years. Old-timers tell of stock prices 20 years ago being driven simply by calculations of dividend yields worked out by long division with pen and paper. Since then, analysts have moved on to myriad other measures of company valuation: PE (price of a share divided by the earnings per share), DCF (discounted cash flow analysis) and EVA (economic value added), to name a few.

Add in complex spreadsheets, option pricing theory, sensitivity analysis and so on, and you could be forgiven for thinking we were all getting much cleverer. But no. Somewhere along the way the analysts had a brain bypass and adopted a measure called EBITDA (pronounced by the cognoscenti as "ebb-it-dah") as an object of focus. This fancy-sounding platoon of letters stands for earnings before interest, tax, depreciation and amortisation.

In the world of financial fashion, EBITDA has been the new black for a number of years. It came to prominence in the technology boom of the late 90s as a way for analysts, investors and companies to look past the losses and negative cash flows streaming from some of the hot growth stocks and find something positive to latch onto.

The ensuing crash showed that was a flawed approach, yet EBITDA lives on as a favoured valuation yardstick despite the fact that as a measure of profit, or as a number to which to apply a ratio for valuation purposes, it is intellectually challenged.

There are many levels at which you can examine the profitability of a business. The final profit number in the profit and loss statement - variously referred to as net profit after tax, net surplus or group profit - is obviously pretty important. This is the amount the accountant reckons shareholders actually made for the year.

Sometimes it's instructive to look at levels of profit prior to arriving at this final number. Profit before tax is often a better indicator of performance if tax rates are changing. Profit before tax and before interest charges (EBIT) is also interesting as it tells how the operations are going prior to the deduction of financing charges, which can vary depending on the company's capital structure and interest rates of the day.

But what is this thing called EBITDA? For the sake of simplicity, let's forget about the A component - amortisation - which only applies to a few companies, and focus instead on depreciation. EBITDA is basically the EBIT profit number referred to above, with one item of cost - depreciation - added. But why measure a company's performance before depreciation, which is a significant and ongoing cost of doing business? Why not rent? Electricity? Wages? EBITR, EBITE, EBITW - just imagine the number of anagrams you could come up with.

Supporters of EBITDA will say it is a measure of operating cash flow because depreciation (and amortisation) is a non-cash charge. That's true, but that does not mean depreciation is not a real cost. The fact that the company car is wearing out and dropping in value is an inescapable cost of doing business, even if the car is not traded in at the end of every year.

In a cash flow sense, the mirror image of depreciation is capital expenditure. Most companies on average spend their depreciation allowance on capex each year. If companies are growing they normally spend more - over time, most companies will display a relatively fixed ratio of assets to sales. There are the odd exceptions to this rule. For companies such as Sky Television and Telecom, the replacement cost of capital equipment has dropped rapidly thanks to technological change and currency movements, so you would expect (once growth has slowed, as in the case of Sky) capex to be less than depreciation for some time. But, even so, it won't be zero, and to confuse EBITDA with cash flow is plain misguided.

Don't just take my word for it. This is what the great investor Warren Buffett had to say on the subject: "References to EBITDA make us shudder. Does management think the tooth fairy pays for capital expenditures?"

The irony is that investors who use EBITDA ratios wind up favouring lower quality companies over top companies. To illustrate the folly of EBITDA analysis, consider two hypothetical restaurant chains whose financials are included in the attached table. Both are assumed to grow sales at 10% per annum, with the ratio of fixed assets to sales remaining constant, and to ultimately make the same operating profit ratio, albeit with a different mix of cash costs and depreciation.

One, a fine dining chain - Petite Franc Ltd - has expensive fit-outs, tables, china and so on and thus relatively high levels of fixed assets and depreciation. The other restaurant company - Kash Flo Co - a cheap Asian chain, mixes recycled formica tables with Briscoes' china to keep its fixed assets to a minimum.

Although Petite Franc Ltd has cost more to set up ($100 million opening fixed assets), Kash Flo Co (fixed assets of $50 million) is the better quality business due to its higher return on capital and superior cash flows. Note Kash Flo Co produces positive cash flows as it grows and Petite Franc Ltd produces negative cash flows. Kash Flo Co would have the ability to pay dividends; Petite Franc Ltd could only do so by increasing debt. This two-year profit model ignores the differing cash flows, but over time Kash Flo Co would grow net profits at a faster rate because of lower interest costs. DCF analysis would naturally favour Kash Flo Co.

Which company would you rather own if you were allowed to buy them both for $100 million? Hint: if the beauty of positive free cash flows hasn't dawned on you yet, simply choose the one that's able to pay you a dividend each year. Yes, you're right: the correct answer is Kash Flo.

But the EBITDA proponents would recommend Petite Franc Ltd on a 2002 valuation to EBITDA ratio of 3.3 ($100 million valuation/$30 million EBITDA), against a ratio of 5 for Kash Flo Co. This is simply because Petite Franc Ltd has higher depreciation, all of which it "spends" each year on capital expenditure.

As this example shows, EBITDA analysis shines an overly flattering light on the company with high fixed asset intensity, and discriminates against a better quality business with lower asset intensity and high returns on capital employed.

So, if EBITDA gives a false picture of company performance, what's a better measure? Should investors look at EBIT? The answer is generally yes, but not always. Where ongoing maintenance capex is likely to be significantly different from depreciation (as with Sky and Telecom) then possibly the best measure to focus on is EBITDA, provided you make an allowance for average maintenance capital expenditure. This effectively gives you a picture of operational cash flow, pre interest and tax.

Unless, that is, the tooth fairy never stopped putting cash under your pillow when you were nine, and you really do believe she foots the bill for keeping the company's plant and machinery up to scratch.

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