Z. Christopher Mercer, ASA, CFA, ABAR, Founder and CEO of Mercer Capital, maintains a blog focusing on “Business Valuation & Ownership in Transition.” This guest post first appeared on ChrisMercer.net on June 17, 2015.
Many market participants and business appraisers refer to EBITDA as one measure of gross cash flow. Some business owners think about the value of their businesses in terms of rule of thumb multiples of EBITDA, say 4x to 6x, or 5x to 7x, or whatever, depending on the industry.
Warren Buffet and others often decry the use of Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA, when speaking about valuation. Mr. Buffet stated in the 2002 Annual Report of Berkshire-Hathaway:
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.
Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
Mr. Buffet is arguing against far more than the use of EBITDA. If I read the above quotes correctly, he advocates accurate financial reporting, reasonable financial disclosure, and, I guess, he is against earnings projections and growth expectations that are discussed by management of public companies, as well as by many investment bankers and analysts for institutional investors.
Mr. Buffet, perhaps the most successful investor in history, seems to take an overall view of a business, and not a single-minded focus on one metric. Who can argue with that?
Mr. Buffet and others are really suggesting that one should never place blind reliance on EBITDA, or simple multiples of EBITDA in valuing companies. If I read the quote above correctly, one should also never invest in companies whose management is untrustworthy. Who can argue with that?
However, focusing on the supposed shortcomings of EBITDA, the same could be said for relying solely on sales, pre-tax earnings, operating cash flow, the condition of the balance sheet, or the need for capital expenditures, among others. Financial analysis and valuation are comprehensive exercises that must take many factors into account.
Is It Okay to Consider EBITDA?
Any valuation analysis that leads to a conclusion needs to consider the many nuances of the valuation triumvirate of expected cash flow, risk and growth. There is no one measure that tells all.
But can we look at EBITDA as an earnings measure to use in developing total capital value indications? Well, yes, and appraisers and market participants do so every day. I don’t think they are all blind. For example, two commonly used valuation methods when valuing public (and private) companies are:
- The guideline (comparable) public company method, capitalizing EBITDA (or expected EBITDA) of a private company based on analysis of EBITDA multiples of similar publicly traded entities.
- The guideline transactions method, capitalizing EBITDA of a private company based on analysis of EBITDA multiples found in transactions involving the sale of similar companies.
Then we have the seemingly ubiquitous rules of thumb that, for example, companies in the widget-gadget industry trade in a range of 4.0x to 6.0x EBITDA, or so. Appraisers and market participants who use rules of thumb like this make the EBITDA naysayers look smart.
However, few analysts depend on only one valuation method, so hopefully, even those analysts, market participants and business owners who consider EBITDA in some fashion are doing something reasonable.
At this point, we will take a partial look at two public companies, Exxon Mobil Corp (XON) and Apple Inc. (AAPL). Exxon is a capital-intensive business and Apple is much less so. We will look at some basic financial information and make a few relevant comparisons. And yes, we will look at EBITDA.
Exxon Mobil and Apple: Two Different Companies
Exxon is a huge, multi-national corporation with diverse operations all over the globe. It has LTM (last twelve months) revenues of $394 billion, total assets of $343 billion, and net fixed assets of $253 billion. The ratio of net fixed assets to total assets is 74%, indicating a relatively high degree of capital intensity. The summary description in Google Finance reads as follows:
Exxon Mobil Corporation is an energy company. The Company is engaged in the exploration and production of crude oil and natural gas. The Company is involved in the manufacturing of petroleum products, and transportation and sale of crude oil, natural gas and petroleum products. The Company also manufactures and markets petrochemicals, including olefins, aromatics, polyethylene and polypropylene plastics, and a variety of specialty products. The Company’s projects include the Kearl project, Heidelberg project, the Point Thomson project, the Hadrian South project, the Lucius project, the Chirag Oil project, the Tapis Enhanced Oil Recovery project, the Damar project, and the Barzan project, among others. The Company is conducting its operations and projects in the United States, Asia, Africa, Canada/South America, Europe and Australia/Oceania.
Apple, on the other hand, sells iPhones, iPads, and other computer and consumer products. It is a large multi-national corporation, as well, with LTM revenues of $183 billion, total assets of $232 billion, and net fixed assets of $20.6 billion. The ratio of net fixed assets to total assets is 8.9%, indicating substantially less capital intensity than Exxon. The summary description in Google Finance reads as follows:
Apple Inc. (Apple) designs, manufactures and markets mobile communication and media devices, personal computers, and portable digital music players, and a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud, and a variety of accessory, service and support offerings. The Company also delivers digital content and applications through the iTunes Store, App StoreSM, iBookstoreSM, and Mac App Store. The Company distributes its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In February 2012, the Company acquired app-search engine Chomp.
The two companies are quite different. Sales of Exxon are more than double sales for Apple. If sales were the primary valuation metric, then we would expect Exxon to be more valuable than Apple. Not so, as we will see.
Now, let’s look at how the market prices both Exxon and Apple, ultimately looking through the eyes of EBITDA. We begin with Exxon.
Exxon Mobil: One Look at EBITDA
Begin with some summary information about Exxon. The market value of equity of Exxon at June 12, 2015 (the day I am writing) is $351 billion. It is a very large company by either sales, assets or market capitalization.
The table shows Exxon’s EBIT ($34.1 billion) and depreciation and amortization (($17.3 billion) and calculates EBITDA for the trailing twelve months ending December 2014 ($51.4 billion). The EBITDA margin (EBITDA/Sales) is 13.0%.
We calculated Enterprise Value at the right of the table just as we discussed in a previous post as the sum of the market value of equity and debt less cash on the balance sheet. Enterprise Value is $376 billion.
With two figures, Enterprise Value and EBITDA, we can calculate the Enterprise Value to EBITDA multiple as 7.3x at the bottom left of the table. We also calculate the Enterprise Value multiple of EBIT at the right side of the table as 11.0x. Notice that Depreciation, which is expensed in arriving at EBIT, accounts for 50.75% of EBIT.
Since the current level of depreciation expense is a function of historical capital expenditures, the ratio of Depreciation Expense to EBIT tells us something about capital intensity. The ratio of net fixed assets to total assets of 73.7% tells us more about capital intensity. The current level of depreciation provides one indication of expectations for future capital expenditures. Exxon’s $17.3 billion of depreciation, one component of EBITDA, suggests capital expenditures on that order or higher in the future if Exxon plans to grow its business.
We create an “EBITDA Depreciation Factor” of 1.51 by adding 50.75% to 1 (EBIT + Depreciation = EBITDA). The EBITDA Depreciation Factor measures the percentage of EBIT that is accounted for by EBITDA. The higher the EBITDA depreciation factor, other things being equal, the higher the implied capital intensity of a business or an industry.
Now, we divide EBIT by the EBITDA Depreciation Factor to get an implied EBITDA multiple of 7.3x, which is precisely the same as the calculated EBITDA multiple at the left side. It should be the same because both of the calculations illustrate the same mathematical result. We will use this Depreciation Factor later in a somewhat different way
Apple: Another Look at EBITDA
Now we look at another public company, Apple Inc. (AAPL), in the same way to see if we develop the same story. The market value of equity of Apple was $733 billion as of June 12, 2015. Apple is a very large company by market capitalization.
EBITDA for Apple is calculated to be $61.5 billion, or significantly greater than Exxon’s EBITDA of $51.4 billion. The EBITDA margin is 29.0%, or more than double that of Exxon’s 13.0% EBITDA margin. If Apple were accorded a 7.3x multiple of Enterprise Value like Exxon, it would have Enterprise Value of $441 billion. However, the Enterprise Value for Apple is $583 billion, compared to Exxon’s Enterprise Value of $376 billion. What has the market figured out?
As an aside, note that Apple had $194 billion of cash on its balance sheet at March 28, 2015. A market capitalization of equity at that level would place a company well in the top decile of all publicly traded companies. For further perspective, the total of the equity market capitalizations of General Motors (GM), Ford (F) and Fiat Chrysler (FCAU) is less than $140 billion. This also illustrates why many analysts prefer the use of Enterprise Value multiples, which exclude cash, over MVTC multiples, which would include cash. For example, if we calculate the MVTC/EBITDA multiple, which considers cash, it would be 12.6x, or more than three “turns” of EBITDA greater than the Enterprise Value EBITDA multiple of 9.5x.
Note that Depreciation represents only 17.1% of EBIT for Apple rather than 50.75% for Exxon. Why? Because Apple is significantly less capital intensive than Exxon, and we know that immediately when we calculate their respective EBITDA depreciation factors. This means that for every dollar of EBIT generated, Exxon has expensed 51 cents of depreciation, which is a proxy for expected capital expenditures, although not a perfect proxy. On the other hand, for every dollar of EBIT generated by Apple, it expensed only 17 cents of depreciation, the proxy for future capital expenditures.
Assume simplistically that expected capital expenditures are equal to LTM depreciation. Under that assumption, Apple generates about 34 cents more (50.75 – 17.1) of cash available for distribution, taxes, or additional reinvestment. The market probably thinks that differential is worth something in pricing.
The EBITDA depreciation factor for Apple is 1.17 versus 1.51 for Exxon. When we divide Apple’s Enterprise Value EBIT multiple of 11.1x (or about the same as the 11.0x multiple for Exxon) by Apple’s EBITDA Depreciation Factor of 1.17 (or noticeably lower than for Exxon), we get an implied Enterprise Value EBITDA multiple of 9.5x, which is some 30% greater than the comparable 7.3x multiple of Exxon.
This analysis is fairly simplistic and does not attempt to take into account differences in expected risk or growth between Apple and Exxon. But we do see that Apple is priced substantially more richly per dollar of EBITDA than the more capital-intensive Exxon. And we also see that looking at EBITDA and its components (EBIT and depreciation and amortization), we can understand some of the markets’ rationale for pricing the two companies so differently.
Look at the EBITDA margins for the two companies: Exxon’s margin is 13.0% and Apple’s margin is 29.0%. What that means is that Apple generates more EBITDA, or gross cash flow, than Exxon ($60.4 billion versus $51.4 billion) on less than half the sales. The markets like that and many other comparisons that can be and are made by public market analysts in making their investment decisions.
At the bottom right of each figure above, we calculate the Enterprise Value to sales multiples. Exxon’s multiple is 0.95x, while Apple’s multiple is 3.45x. Exxon is priced at 95 cents per dollar of sales while Apple is priced at $3.45 per dollar of sales. Each dollar of Apple’s sales is priced much more richly that Exxon’s sales dollars. Why? because each dollar of sales at Apple generates substantially greater cash flow than dollars of sales at Exxon.
Maybe EBITDA does tell us something – if we look at its components and a lot of other things that impact value.
Don’t ever let it be said that EBITDA – or anything – tells all in valuation. I just want to lay some groundwork for a different perspective on the single-period income capitalization model relying on EBITDA as a measure of cash flow. However no one valuation method nor one valuation metric is sufficient to capture the essence of business valuation.
As I’ve said before and will say again, valuation is all about expected cash flow, risk and growth. Any analysis that does not consider the many nuances of this valuation triumvirate will be flawed.
- Building EBITDA Multiples Using the Adjusted CAPM
- The EBITDA Depreciation Factor
- Equity-Based Compensation: Are Non-GAAP Earnings Misleading?