be
BE
Belgium
en-BE
be_inst_classes
inst
Institutional
en
en
For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients).
Man with clipboard looking over oil barrels

Insights

EBITDA and the perils of tooth-fairy investing

Gregory Turnbull Schwartz
Senior Analyst, Fixed Income

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
Figure 1: Comparisons of leverage measures

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*
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*
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.

Key topics

Subscribe to insights

Get the most out of your email by tailoring the types of insights and information you would like to receive from us.

Latest articles

Company measures based on EBITDA are common in credit investing, even though it doesn’t project a full picture. So, what does Columbia Threadneedle do differently to get a more holistic view?
Our fixed income team provide their weekly snapshot of market events.
US mega-cap tech stocks drove strong equity returns whereas bonds had a largely dull year. Is the stage set for continued US outperformance in 2025?
Key topics
Related topics

PDF

EBITDA and the perils of tooth-fairy investing

1 Berkshire Hathaway INC, 2000 Annual Report, 2021

Important information:

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.

In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge who meet the regulatory criteria to be classified as a Professional Client or Market Counterparty and no other person should act upon it. This document and its contents and any other information or opinions subsequently supplied or given to you are strictly confidential and for the sole use of those attending the presentation. It may not be reproduced in any form or passed on to any third party without the express written permission of CTIME. By accepting delivery of this presentation, you agree that it is not to be copied or reproduced in whole or in part and that you will not disclose its contents to any other person.

This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

Related Insights

17 December 2024

Fixed Income Desk

In Credit - Weekly Snapshot

In Credit Weekly Snapshot – December 2024

Our fixed income team provide their weekly snapshot of market events.
9 December 2024

Rosalie Pinkney

Credit Research Analyst, Fixed Income

European banks: strong fundamentals and pockets of value

It’s a sector which we’re positive on, for several reasons ranging from regulation and valuations to fundamentals.
26 November 2024

Fixed Income Desk

In Credit - Weekly Snapshot

In Credit Weekly Snapshot – November 2024

Our fixed income team provide their weekly snapshot of market events.
17 December 2024

Fixed Income Desk

In Credit - Weekly Snapshot

In Credit Weekly Snapshot – December 2024

Our fixed income team provide their weekly snapshot of market events.
16 December 2024

Steven Bell

Chief Economist, EMEA

Closing Bell 2024 : ‘Immaculate disinflation’ and the ‘Magnificent Seven’

US mega-cap tech stocks drove strong equity returns whereas bonds had a largely dull year. Is the stage set for continued US outperformance in 2025?
13 December 2024

Sally Springer

Senior Sustainable Research Analyst, Global Research

It’s a value trap! How research intensity can help reveal genuine recovery stocks

With intangible asset growth increasingly a driver of performance growth, a core research theme for us is ‘human capital’. It's just one way our Global Fundamental Research Group feeds into our investment process.

Important information:

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.

In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge who meet the regulatory criteria to be classified as a Professional Client or Market Counterparty and no other person should act upon it. This document and its contents and any other information or opinions subsequently supplied or given to you are strictly confidential and for the sole use of those attending the presentation. It may not be reproduced in any form or passed on to any third party without the express written permission of CTIME. By accepting delivery of this presentation, you agree that it is not to be copied or reproduced in whole or in part and that you will not disclose its contents to any other person.

This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

You may also like

Investment approach

Teamwork defines us and is fundamental to our investment approach, which is structured to facilitate the generation, assessment and implementation of good, strong investment ideas for our portfolios.

Funds and Prices

Columbia Threadneedle Investments has a comprehensive range of investment funds catering for a broad range of objectives.

Our Capabilities

We offer a broad range of actively managed investment strategies and solutions covering global, regional and domestic markets and asset classes.

Thank you. You can now visit your preference centre to choose which insights you would like to receive by email.

To view and control which insights you receive from us by email, please visit your preference centre.

Woman listens to music through headphones
Play Video

CT Property Trust- Fund Manager Update

Sed ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium