EBITDA makes it easier to compare the profits of different companies

One of the major problems with EPS is that it is very sensitive to different ways of calculating depreciation, whether a company is financed with debt or shareholder's equity, and the rate of tax it pays on profits. EBITDA avoids this problem.

Take a look at the two companies shown in the table below to see what I mean.

£m	The Supermarket	The Grocer
Borrowings	250	0
Shareholders' Equity	250	500
Capital employed (money invested)	500	500
Turnover	500	500
Depreciation & Amortisation	-50	-50
Other operating costs	-400	-400
EBIT	50	50
Interest @ 10%	-25	0
Profit before tax	25	50
Taxation @ 20%	-5	-10
Profit after tax	20	40

The Supermarket and The Grocer are two privately owned food stores in the same town. They have identical assets, turnover and EBIT. The only difference between them is that The Supermarket finances half its assets with a bank loan whereas The Grocer has no borrowings at all.

Yet looking at profits after tax, you could easily be forgiven for thinking that The Grocer is a much better company because it makes twice as much as The Supermarket. You might also think that this would make The Grocer a more valuable business. Not so.

Let's say The Grocer sells itself to a rival company. The buyer pays an enterprise value (a value for all its assets) of £800m. The Supermarket sees this and starts thinking about how much it might be worth.

The owners of The Supermarket are a little old fashioned when it comes to financial matters which means they can get confused easily. They work out that the £800m paid for the Grocer equates to 20 times post-tax profits - a PE of 20.

Ignoring the fact that The Grocer has no debt and the £800m paid is for all the assets - it's an enterprise value - The Supermarket reckons that it could pocket £400m from selling up (20 x £20m) because its post-tax profits are half those of The Grocer's.

Then they think they can be a little bit clever and boost profits so they can sell out at a higher price. If they cut their depreciation charge by £10m (by assuming that their assets can last longer), post-tax profits would go up to £28m which would mean that the equity would be worth £560m (20x £28m) - an extra £160m. This won't happen because the buyer is looking at the company's EBITDA which won't be affected by this.

Remember, these businesses are identical except for the way they are financed. Even with a reduction in depreciation by The Supermarket (shown in the middle column in the table below) they would both still have the same EBITDA - £100m. They should both be worth the same amount; they should have the same enterprise value (EV). The Supermarket is making the same mistake that many investors make when trying to compare businesses.

£m	The Supermarket	The Supermarket (adj)	The Grocer
EBIT	50	60	50
Add Dep &Am	50	40	50
EBITDA	100	100	100

They are letting the fact that a company has debt and a different depreciation policy confuse them. The company with debt will pay interest on that debt which means that it will have lower post-tax profits than an identical company with the same EBITDA but no debt. That doesn't mean that the value of its assets are worth less. That's like saying that two identical houses next door to each other should sell for different prices because one has a mortgage secured against it and the other doesn't.

The buyer of a company - just like the buyer of a house - is paying for all the assets. This means that they are paying for the shareholders' equity and also taking on any debts and other liabilities at the same time. They are focusing on the company's enterprise value and looking at what they might get back in return.

By ignoring the differences in financing, tax and depreciation and concentrating on EBITDA instead, The Supermarket should be asking £800m for its business too - an EV/EBITDA valuation of 8 times.

The debt will make a difference to the actual returns for the shareholders. Because the value of The Supermarket includes a debt liability of £250m, the buyer will want to deduct this from the cash handed over to the owners. So whereas the owners of The Grocer would receive the full £800m (because it is debt-free), the owners of The Supermarket would receive £800m minus £250m - £550m.

£m	The Supermarket	The Grocer
EBIT	50	50
Add Dep &Am	50	50
EBITDA	100	100
Price paid/Assumed (8x EBITDA)	800	800
EV/EBITDA paid	8	8
Take away debt	-250	0
Money left over for shareholders	550	800

EBITDA makes companies look safer

One of the key checks of how safe a company is as an investment is looking at its ability to pay the interest on its debts. This is usually done by calculating its interest cover (EBIT divided by interest paid) and looking at how many times current profits can cover the interest bill. By using EBITDA instead of EBIT to calculate this ratio you can make the interest cover number bigger - sometimes a lot bigger - which results in a company looking a lot safer.

Let's look at Vodafone again. As you can see, EBITDA interest cover makes you think that the company can very comfortably pay the interest on its debt. The more conventional calculation based on EBIT suggests that this is more of a challenge.

The problems with EBITDA

To some, EBITDA is the holy grail of investing numbers. It makes the analysis of company profits and valuations seem quite simple. Unfortunately, EBITDA is one of the most flawed and abused numbers in finance. Here's why.

EBITDA is not the same as cash flow

Depreciation is an expense charged against a company's income. Its purpose is to match the cost of tangible fixed assets such as buildings or machines against the revenues they produce over their useful lives.

Say a company buys a piece of equipment for £1m which will last ten years and will be worth nothing at the end of its life. It will charge £100,000 of depreciation against its revenues for the cost of this machine for the next ten years. This will reduce the company's profits (EBIT) by the same amount.

This depreciation is not a flow of cash. The cash flow is the £1m used to buy the equipment in the first place. The supporters of EBITDA therefore argue that this depreciation has to be added back to EBIT to get a more realistic view of a company's profits. Some say that EBITDA is a good proxy for a company's trading cash flow.

However, at the end of ten years the equipment will have to be replaced. Depreciation can therefore be seen as an estimate - sometimes not a very good one - of the amount of money that needs to be set aside each year to eventually buy a new piece of equipment (although in the real world the amount needed is often more than this as the price of new equipment tend to be more expensive than prices ten or more years ago). In financial jargon this is known as maintenance or "stay in business capex", a subject I've written about a lot in recent weeks.

If a company does not replace its assets then it will find it hard to make any money at all eventually. Depreciation is therefore a real cost to a business and is not money that can be used to pay interest on debts or dividends to shareholders for very long.

The important thing to consider when looking at any measure of profit or cash flow, particularly when it is also used to value a company is that it has to reflect an amount of money that is left over to pay lenders and shareholders. A company that doesn't replace its assets will eventually stop making money which means that EBITDA is a bad measure of company profits and cash flow.

Another serious problem of EBITDA is that it doesn't take into account a company's working capital needs. Working capital is the money that a company needs to operate on a day-to-day basis. Some companies need more of it than others. That's because they might need to hold lots of stock to meet customer orders, pay for things in advance and sell goods to customers on credit. All this can be a drain on a company's cash resources, so it might need to invest cash in the business so that it can pay its daily running costs. This is cash that can't be paid out to investors.

On top of working capital, a company might be making top up payments to its final salary pension scheme to help plug a deficit. It also might be spending cash on restructuring the company. The cash spent here is not reflected in EBITDA. But it is used to calculate a company's operating cash flow which is a much more meaningful number.

As you can see, there have been significant differences between Vodafone's EBITDA and operating cash flow during the last ten years (although they are now fairly similar).

Forget about EBITDA - focus on cash profits instead

Create a custom results table in SharePad as shown below. Then export it to a spreadsheet.

You can then have a go at working out a company's real cash profits and then see how its valuation stacks up on that measure rather than using EBITDA which might give you a misleading answer. To work out cash profits you need some estimate of "stay in business capex" (click here for more on this subject). There is no right answer unless the company tells you what it spent in its annual report (a few companies are quite helpful in this respect). I have used five year average capex figures as an estimate of this which SharePad has calculated for me.

Based on the numbers taken from SharePad, I have then performed the following calculations.

Vodafone plc	2012	2013	2014	2015
EBITDA less capex	15388	4419	3808	2699
% of EBIT	100.05%	80.73%	128.17%	133.81%
EBITDA less 5yr average capex	16213.4	4504.8	2949.8	3619.2
% of EBIT	105.41%	82.29%	99.29%	179.43%
FCFF	8929	6649	4411	1415
add back capex	7852	7716	6723	8883
less Capex 5y avg	-7026.6	-7630.2	-7581.2	-7962.8
Adjusted FCFF	9754.4	6734.8	3552.8	2335.2
Valuations:
EV/EBITDA	5.6	10.8	5.9	6.3
EV/EBIT	8.5	23.9	20.9	36.2
EV/EBITDA - Capex	8.5	29.6	16.3	27.1
EV/EBITDA - Capex 5y avf	8.1	29	21.1	20.2
EV/FCFF	14.7	19.7	14.1	51.6
EV/FCFF (adj)	13.4	19.4	17.5	31.3

EBITDA less capex is a good starting point for working out a company's cash trading profits. However, this measure does ignore movements in working capital and the payment of tax. Free cash flow to the Firm (FCFF) takes both into account. This makes it a very good number for weighing up a company.

I have adjusted FCFF for five year average capex to give me an estimate of Vodafone's after tax, cash based trading profits. If I compare this with its enterprise value (EV) then what I have effectively created is a debt-adjusted cash PE ratio.

So if you think Vodafone shares are cheap because they have an EV/EBITDA ratio of 6.3 times you might want to think again. The EV/FCFF (adj) of 31.3 is saying that they are very expensive.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.