Inflexible friend – EBITDA is not a perfect measure but it is less easily manipulated in accounts


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

Here on The Value Perspective we talk a lot about a particular measure of a business’s profits known as ‘EBITDA’ – an acronym that stands for ‘earnings before interest, taxes, depreciation and amortisation’. It therefore seemed useful to take some time to explain what it is, what it is not and why we use it. The following – entirely fictional – tale is intended to help by offering some context.

Losing heart after another poor bonus season, Val Hooper-Spectif decides to give up his job as a fund manager and set up what he sees as a real business. He goes onto eBay and buys an automated carwash for £40,000. It is in a good state of repair and Val thinks it should last him five years. He installs the machine on his leafy surrey driveway and, as a result, incurs no other start-up costs.

The detergent used in the carwash and the resulting utility bills amount to 20p per wash and Val is able to charge £2 per wash. Back in his former job, Val would have referred to that £1.80 of profit per wash as the business’s ‘gross profit’. He would also have calculated the business’s ‘gross profit margin’ as 90% by dividing its gross profit by its revenue (£1.80 / £2.00).

In the first year, the carwash performs 5,000 washes, taking in £10,000 in cash and making £9,000 of gross profit. Val, who was never very good at maths, pays an accountant £1,000 a year to do his books so his gross profits less administrative costs are £8,000. This is his EBITDA – his earnings before taking into account any interest and tax owed or any depreciation or amortisation on the business.

Like death, taxes (and indeed any interest owed to banks) are unavoidable, so Val’s EBITDA will clearly not be the same as his take-home profit. Once depreciation has been accounted for and tax and any interest have been paid, we are left with net income, which is generally referred to as ‘earnings’.
Tax and interest owed are likely to be depressingly familiar ideas, so let’s deal with the concept of depreciation next.

Val’s carwash machinery will not last forever. He cannot go on making £8,000 profit each year into perpetuity without reinvesting in his business. Since Val believes the machinery will no longer work – and will therefore be worthless – after five years, the £8,000 EBITDA number is not a realistic estimate of Val’s sustainable long-term profits on his initial £40,000 investment.

How then should Val estimate his sustainable profits? As he expects the machinery to last five years, he should take its £40,000 cost and charge his profit & loss account one-fifth of this amount each year (its depreciation). Thus the sustainable pre-interest, pre-tax profit in each year is the EBITDA minus the burden of replacing the machinery, which is proportionately allocated evenly in each year.

Since we are including depreciation in our calculation, this metric is just the EBIT of ‘earnings before interest and taxes’. (yes, well spotted – we dropped an ‘a’ as well as a ‘d’ there. however, while depreciation relates to property and physical equipment, such as carwashes, amortisation deals with intangible assets, such as patents and licences, so the difference is irrelevant for this illustration.)

Anyway, on this basis, Val’s investment does not look so shrewd. Once we account for depreciation, he made zero profit in the year – £8,000 EBITDA less the £8,000 annual depreciation charge. As Val made no profits, we can guess that he paid no tax. Clearly the differences here are huge so let’s just check the maths is correct.

Under the EBITDA measure, Val would be expected to make £40,000 profit over five years. However, at the end of year five, Val would need to buy a new carwash. If instead he decides not to bother and terminates the business, he will have earned back the £40,000 he had in the beginning and made no profit, which is what we were shown by the EBIT profit measure.

But, if EBITDA overestimates the profits of businesses, then why do we talk about it on The Value Perspective? Well, suppose Val wanted to sell his business – how could he ‘massage’ his accounts to make it appear more attractive to investors? He has limited control over the traffic through his carwash and presumably he is already doing his best to maximise throughput and prices and to minimise costs.

However, accounting rules do give Val some flexibility on how his profits are presented to investors. He has one big accounting choice to make – the estimated life of his machinery. If his accounts are audited, his auditors may ask him to justify his estimate of its useful life but they will probably not be specialists in the field of automated carwashes and so will tend to defer to the manager’s expertise.

If Val decides – or pretends – that the equipment will last for 10 years, then the EBIT profit measure will appear very different. EBITDA would be unchanged at £8,000 a year but we would only subtract one tenth of £40,000 each year to arrive at an EBIT of £4,000! Val has no interest to pay and UK corporate taxes are 21% (£840), so his reported earnings would be £3,160.

As this example shows, EBITDA may be an incomplete measure of sustainable profitability but it is less biased by accounting choices – and less open to manipulation – than EBIT. The way we typically use EBITDA on The Value Perspective is to take it as a base profit and then subtract our estimate of the capital investment that is required each year to maintain the enterprise’s operating assets.

From this number, which we call ‘cash EBIT’, we can then subtract interest expenses, working capital investments and taxes to arrive at a figure for the sustainable free cashflow generated by the enterprise. The crucial next step, which many investors fail to do, is to compare cash EBIT and free cashflow to the investors’ capital that was used to generate these profits.

We will address that in more detail in a future article on enterprise value but, for now, suffice to say investors may be willing to pay 12x Val’s estimate of sustainable profits of the business in the belief they can earn a reasonable 8.3% sustainable return on their investment (1/12 = 0.083) without having to assume the business grows over time. This estimation implies a market value of £37,920.

It is, however a mis-estimation and one that benefits Val greatly. At the end of the first year he has taken out £7,160 from the business (£8,000 of EBITDA minus his tax bill of £840). He can then sell the business under false pretence to pocket a total £45,920 – a handsome 14.8% return on his initial investment. Do that with a large enough initial investment and you can start to see how Enron came about.


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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