Rethinking Company Valuations: The Case Against EBITDA#

Charlie Munger, the legendary business partner of Warren Buffett, once said: “Whenever you see EBITDA, you should replace it with ‘nonsense earnings.” While his statement might seem extreme, it underscores significant issues with relying on EBITDA for valuing businesses. Let’s explore why.

What’s Wrong with EBITDA?#

EBITDA—short for Earnings Before Interest, Taxes, Depreciation, and Amortization—is often promoted as a way to evaluate operational profitability. However, it fails to account for several crucial factors:

  • Depreciation: Assets degrade and need replacing over time. Ignoring depreciation means ignoring the ongoing investment required to sustain operations.
  • Taxes: Taxes are unavoidable expenses that directly impact the actual profits of a business.
  • Debt Costs: Interest payments on loans are real financial obligations that affect cash flow and profitability.
  • Equipment Replacement: Ignoring the need for reinvestment in equipment paints an incomplete picture of financial health.

The Problem with “Adjusted EBITDA”#

The financial world has taken EBITDA a step further with “Adjusted EBITDA,” which often involves removing “one-off” or “unusual” expenses. This practice can manipulate the numbers to present an overly favorable financial position, further distorting reality.

The True Value of a Business#

Ultimately, the value of your business is determined by what someone is willing to pay for it. While buyers may use various valuation methods, here is a practical and realistic framework:

A Practical Valuation Formula#

  1. Net Profit Before Tax: Apply a multiplier of 1.5x to 3.5x based on the business’s characteristics. You can find this number on the Income Statement, listed as “Profit Before Tax” or “Earnings Before Tax (EBT).”
  2. Add: Net Assets (e.g., property, inventory, equipment). This is found on the Balance Sheet as the total of “Assets” minus “Liabilities.”
  3. Subtract: Liabilities (e.g., loans, outstanding debts). Look at the Balance Sheet under the “Liabilities” section, which details short-term and long-term obligations.
  4. Add: Free Cash (cash reserves not tied to operations). This is located on the Balance Sheet under “Cash and Cash Equivalents.”

Factors Influencing the Multiplier#

  • Strength of Leadership: Competent management adds significant value.
  • Revenue Diversity: Heavy reliance on a few clients reduces appeal.
  • Predictable Revenue Streams: Recurring income increases the perceived stability.
  • Future Growth Opportunities: A business with growth potential commands a higher valuation.
  • Industry Trends: Sectors with strong demand or less risk attract higher multiples.

Example Valuation: A Business Worth €2.375 Million#

Let’s say a company generates an annual net profit (before tax) of €850,000 and has the following financial details:

  • Net Assets: €50,000 (found on the Balance Sheet as Total Assets minus Total Liabilities).
  • Liabilities: €200,000 (listed under the Liabilities section on the Balance Sheet).
  • Free Cash: €100,000 (found on the Balance Sheet under Cash and Cash Equivalents).

Using a multiplier of 2.5x for its net profit, the valuation would be calculated as follows:

  • Net Profit Valuation: €850,000 x 2.5 = €2,125,000
  • Add Net Assets: €2,125,000 + €50,000 = €2,175,000
  • Subtract Liabilities: €2,175,000 - €200,000 = €1,975,000
  • Add Free Cash: €1,975,000 + €100,000 = €2,375,000

Thus, the company’s total valuation would be €2.375 million.

The Bottom Line: Net Profit Matters Most#

As the old saying goes:

  • Revenue is vanity
  • Adjusted EBITDA is fantasy
  • Net Profit Before Tax is reality

For a clear and honest valuation, focus on metrics that truly reflect a business’s profitability. While EBITDA and its adjusted versions may look appealing on paper, net profit before tax gives a far more accurate and reliable picture. Remember, numbers don’t lie—but they can certainly be manipulated. Stick to reality when valuing your business.

Call to Action#

If you would like to discuss your company’s valuation or explore opportunities to connect with investors, please don’t hesitate to contact me. For more insights, check out this YouTube video, where Charlie Munger makes his statement at minute 5:47.

Interactive Valuation Calculator#

I’ve created a very simple, HTML/JS-based calculator to play around with your key metrics.

Find it here.