Key Takeaways
- Earnings before interest, tax, depreciation and amortisation is a measurement of a company’s financial performance, but as it’s higher up the income statement it ‘ignores’ substantial items
- Measures based on EBITDA are common in credit investing, even though it doesn’t project a full picture. So, what can we do about this?
- By combining an EBITDA measurement with other financial perspectives we can gain a fuller picture around a company’s position – this is an example of using multiple perspectives within our company research to better inform the conversation between portfolio managers and analysts
Earnings before interest, tax, depreciation and amortisation – or EBITDA – is a measure attributed to John Malone, billionaire of media sector fame. Because he and his team were reportedly rather creative when it came to tax, and intended to use lots of leverage in acquisitions, being able to ignore tax and the cost of that leverage was very useful. Rather than presenting financials to potential investors at the net income level, they moved way up the income statement, ignoring substantial costs – what a concept.
As well as the cost of debt, EBITDA ignores the day-to-day capital needs of a firm (its working capital) and the cost of longer-term “permanent” capital, or assets. In his straight-talking way, Warren Buffet addressed this in the Berkshire Hathaway annual report of 2000: “References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures?”.1
Measures based on EBITDA are common in credit investing. Debt less cash (net debt) divided by EBITDA is frequently used to compare various firms. It tells you how many years of EBITDA are required to repay a firm’s net debt. But so what? Firms can’t repay debt with EBITDA; they have to pay tax and interest and replace depreciating assets in most cases – and typically, as all of us experience in our daily lives, the replacement cost is higher than the book value. A fair question, then, might be “Why do we do this?”, but a more useful question is “What should we do about it?”.
How about looking at cashflow? The cashflow statement is not without its flaws, but after some years of being in the investment industry I would wager that it is typically closer to the truth than the income statement. If we take operating cashflow, which begins with net income and adjusts for items that are not “operational” in nature and items which are non-cash, and then deduct capital expenditures from that, we get to “free cashflow”.
This is not perfect, but arguably a company could repay its debt from free cashflow. At the point of free cashflow, a company has accounted for normal operational items including the day-to-day liquidity requirements, as well as the required ongoing investment it must make. Perhaps if one is a bit sceptical – for example that the company has recently been reducing capex below the required levels – one can make an adjustment of sorts. This is one of the many ways an analyst may change reported financials to better reflect their view about the actual condition of the company. Using the free cashflow figure in the denominator, and net debt in the numerator, provides a clearer measure of the length of time it would take the company to repay its debts.
Without knowing or thinking about this any further, you might guess that net debt/free cashflow will be higher than net debt/EBITDA for most companies – ie it will take longer to repay debt from cashflow than from the tooth-fairy measure.
Plotting companies in the same industry on charts with both measures can highlight some differences. And yes, it is typically true that the free cashflow-based measure will be higher than the EBITDA-based measure. But the assessment flags situations that are important to individual companies: some do not fall in line with their peers and the reason why is sometimes worth knowing.
Within the Chemicals sector, for example, two material differences stand out: BASF and Air Products. The comparison of BASF, Dow Chemical Company and LyondellBasell shows a very different relationship despite their core businesses having significant overlap (Figure 1). They each appear to be about 2-2.5x on the net debt/EBITDA measure, but when we look at net debt/free cashflow BASF is much higher (6x) versus LYB (about 2.8x).
Figure 1: Comparisons of leverage measures – net debt/EBITDA and net debt/free-cash flow
Source: Analysis of company accounts by Columbia Threadneedle Investments, data as at year-end 2023. Key: AIFP, Air Liquide; APD, Air Products and Chemicals Inc; BASGR, BASF SE; DOW, Dow Inc; DD, DuPont; IFF, International Flavours & Fragrances; LIN, Linde Plc; LYB, LyondellBasell Industries NV
BASF had a very bad 2023. It is also investing heavily, largely to de-emphasise its exposure to Germany where energy policy has become very difficult for chemicals production, and to increase its exposure to China. Capex comes out of the free cashflow measure and is reflected in BASF’s position in Figure 1. Within the industrial gas companies, Air Products is the clear outlier. It is below the 0 line and its peers, Air Liquide and Linde, are above the 0 line and near one another. This is because of a huge capital expenditure program in hydrogen-related assets causing Air Product to have a significantly negative free cashflow. Would the keen investor know these things without the chart?
Probably. But it does highlight the degree to which the measures used could influence perception. For example, BASF is not normally regarded as more heavily debt-burdened than Dow.
How can we use this type of lens to help us better view and interpret relative value opportunities? As with so many topics in so many genres, the answer is “it depends”. There are times when this will add nothing to the conversation, but at other times using multiple leverage views enhances our perspective and highlights opportunities or cautionary indicators. Figures 2 and 3 use recent spread levels and the fundamentals from the end of 2023, just for illustration.
Figure 2: net debt/EBITDA against G-spread*
Source: Analysis of company accounts by Columbia Threadneedle Investments, data as at year-end 2023. See Figure 1 for key. *G-spread (or nominal spread) is the difference between the yield on Treasury bonds and the yield on corporate bonds of same maturity
Figure 3: net debt/free-cash flow against G-spread*
Source: Analysis of company accounts by Columbia Threadneedle Investments, data as at year-end 2023. See Figure 1 for key. *G-spread (or nominal spread) is the difference between the yield on Treasury bonds and the yield on corporate bonds of same maturity
If we did not have the benefit of Figure 3, we might still like Lyondell; but that chart strongly accentuates that LYB is possibly even less leveraged than BASF and Dow, offering greater compensation. The Dow and BASF relationship is flipped around when we see it using free cashflow. The reason for that is a genuine risk factor. As mentioned, BASF is engaged in a massive pivot from Germany to China which has required very substantial investment and has execution risk, which Dow has not had to do. EBITDA doesn’t care about such things, but free cashflow does.
Our analysis of what compensation we ought to receive for owning risk A or risk B involves much more than leverage metrics, but this is an example of using multiple perspectives to form part of the conversation and analysis.
