Many agents have asked us why we categorize EBITDA as one of the “Valuation Voodoo” methods of valuing agencies. Here is the background and reasons that if we cast EBITDA calculations, we do so only as one of many valuation methods and never one of comparison with other agencies or as a measure of quality or final value of an agency.
EBITDA, (Earnings Before Interest, Taxes, Depreciation and Amortization) has generally fallen out of grace since its introduction as a measure of value early in the 1980’s. Originally intended to identify true value of leveraged buy-outs, it gave investors the knowledge of whether a company could meet its short-term financial obligations.
As the concept of EBITDA spread to a wider range of businesses, many people began equating EBITDA with cashflow, although the two are not exactly the same. These business people said that EBITDA could more properly reflect true company performance when eliminating arbitrary calculations, like depreciation and amortization. EBITDA shows more profit than just actual operating profits, and this is important for the dot-coms and any industry where profits are harder to establish because of continuous investment in infrastructure and technology.
Here are the problems with EBITDA as a calculation of value:
1. EBITDA is not actually equivalent to cashflow. Taxes and interest are REAL cash expenses, not operating expenses. It ignores capital expenditures. While not as urgent in the insurance agency industry as in other types of companies, technology and telecommunications are drains in many progressive agencies on a fairly regular basis.
2. EBITDA makes a company look like it has more money than it really does to make interest payments. Those agencies that are heavily leverages can reflect a strong EBITDA and be totally underwater considering its interest obligations.
3. Earnings can be easily manipulated. How good is EBITDA if a smart agent simply inflates revenues or changes his compensation to make earnings look strong?
EBITDA has never been accepted as a generally accepted accounting principle, so companies can report EBITDA in whatever fashion they wish. It doesn’t give a complete picture of the company’s performance. We recommend that you, like we, consider EBITDA, but only as one of a number of measures of agency value. Remember the dot.com bubble some years back? It caused so many investors to put money into companies that had no chance of earning legitimate profits and it was EBITDA that showed profit potential in companies that couldn’t support those projections and were functionally bankrupt.
As we do in our valuations and teach agents for their valuations, Operating Cash Flow is a better measure of how much cash a company is generating. It’s better because it not only adds depreciation and amortization back to net income but it also includes changes in working capital that also use or provide cash. The Working Capital is largely ignored by all but professional appraisers, but it will tell you whether or not the company is making enough sales to make money.