EVA, Not EBITDA: A Better Measure of Investment Value

Bennett Stewart is a Senior Advisor at Institutional Shareholder Services, Inc. This post is based on his ISS memorandum.

There’s no doubting the popularity of EBITDA—earnings before interest taxes depreciation and amortization—as a measure of investment value. Analysts like EBITDA because it removes the vagaries of depreciation and taxes and is unaffected by company leverage ratios. EBITDA is certainly a useful indicator of the gross cash operating profit performance of a business. But is it a reliable way to measure the value of a company?

The short answer is, no, not at all. EBITDA is far less correlated to market value than is commonly thought, and it is riddled with omissions and distortions that make it a highly unreliable guide to how well a company is performing. There also is a much better valuation and performance assessment metric, so much better that investment managers should consider adopting it to replace—or at a minimum, augment—EBITDA in their equity evaluation processes.

In this post, we explore the shortcomings of EBITDA by comparing it with EVA (Economic Value Added), which measures a firm’s true economic profit after deducting a full, weighted-average cost-of-capital interest charge on the net assets used in the business.

EVA is effectively the exact opposite of EBITDA. It is measured after taxes, after setting aside depreciation and amortization as a proxy for the cash needed to replenish wasting assets, and after ensuring all investors, lenders and shareholders alike, are rewarded with a competitive return on their capital. EVA is the true bottom-line profit score that directly discounts to value.

Our empirical review suggests that stock values are determined by the EVA profits that companies generate, and that EBITDA multiples are plug figures—a byproduct of valuation, but not a cause of it.

In our analysis of the Russell 3000, we find that EBITDA explains only 9 percent of variations in Enterprise Value, while EVA explains 22 percent.

In a second test, we examined the values of companies within distinct sectors. Here again, EVA has a higher explanatory power. The median r-squared in explaining Enterprise Value within 43 industry groups is 38 percent for EBITDA and 57 percent for EVA.

Investors that begin to use EVA will be able to value companies more accurately and with greater insight into the performance factors and assumptions that are determining the value.

What EBITDA Misses

Because of its valuation shortcomings, EBITDA can lead to bad decision making. Some of its shortcomings include:

  1. EBITDA does not encourage discipline around soliciting or investing capital. Managers need never worry about generating a decent return on capital or even a return of the original capital investment because capital, in the EBITDA world, is a free resource.
  2. EBITDA ignores the value of managing assets and accelerating asset turnover, which results in releasing superfluous capital.
  3. EBITDA systematically understates the value of outsourcing. Consider a company that sells its technology assets and converts to third-party cloud operations. Profit-and-loss (P&L) costs increase to pay for the outsourced services, which reduces EBITDA. But EBITDA ignores the benefit of selling the associated assets and releasing capital.
  4. EBITDA overstates the value of vertical integration. Why ever farm out production or distribution, and give up some margin? The correct answer is that shedding capital may be worth more than losing the margin. But again, EBITDA is blind to that.
  5. EBITDA favors higher margin products and services, regardless of the additional capital those lines may need compared to lower margin lines.
  6. EBITDA sees no benefit in lowering a company’s tax bill or deferring taxes or using up loss carryforwards.
  7. With EBITDA, there’s never a value to selling or exiting a business if it is cash profit positive. And yet, selling or exiting poor performing and time-sapping units and lavishing attention on the remaining ones can add a lot value.
  8. EBITDA is distorted by bookkeeping rules that do not always reflect economic reality (for instance, expensing R&D outlays, or deducting reported pension costs).
  9. EBITDA is not mathematically connected to value.

Fund managers and equity analysts are generally aware of these shortcomings—they are, after all, financially sophisticated. Many investors address these handicaps by looking at supplemental measures such as working capital turnover, capital expenditures-to-sales ratios, return on capital or earnings per share. But investors can do that only by overruling what EBITDA is saying, and only by adding complexity and ambiguity to the investment equation. There is a better way. Instead of rationing capital, charge for it. Instead of following many metrics, start with an overarching score, namely EVA, and use other metrics to explain that.

EVA is a Superior Analytical Tool

Start with this: EVA is directly linked to value via the basic finance concept of net present value. To be specific, the present value of a forecast for EVA is always identical to the net present value, or NPV, of the forecast cash flows. This is not an assertion. It is mathematically true. By deducting the capital charge, EVA automatically sets aside the profit that must be earned in each period to recover the value of the capital that has been invested or will be invested, which means that EVA always discounts to the premium over, or discount under, the capital invested in the business. To increase EVA is to increase a company’s NPV, share price, and total shareholder return—by definition. Nothing of the sort can be said for EBITDA.

EVA, moreover, provides a single overarching score to quantify how well a company is performing. Consider that, if a company’s EVA is rising, it must be making progress in some combination of:

  1. Operating Efficiently: When a company cuts costs or charges higher prices, that is, when it finds ways to raise profits without raising capital, its EVA clearly benefits. Granted, there’s no specific advantage to EVA here—many other performance measures also suggest these moves are wise. But EVA is not missing them either.
  2. Managing Assets Effectively: EVA goes far beyond P&L optimization, however, because it is the only profit performance measure that fully and correctly increases when balance sheet assets decrease. When managers accelerate asset turnover and streamline the company’s supply chain, they release expensive capital and add to EVA. When they prune marginal plants, products, and markets, or exit businesses that aren’t covering the cost of capital, they can add to EVA—even if this means they forfeit sales, EBITDA, or profit margin. And when managers misallocate capital and cannot cover the ongoing cost, EVA suffers. There’s a built-in discipline for investing capital wisely.
  3. Growing Profitably: EVA is more than a just capital cop, though. It is also a cheerleader, roundly applauding companies that put more capital to work to innovate, scale, and fuel growth, so long as the return on the capital exceeds the cost of raising the capital. And unlike return on investment (ROI), EVA measures the value added by all profitable growth opportunities with returns above the cost of capital, even if those returns are projected to be lower than the ROI the firm is currently earning. EVA, in short, correctly measures performance at the margin without being distorted by legacy decisions or legacy capital.
  4. Optimizing Tradeoffs: EVA also recognizes the value that company management creates when they make optimal choices, considering the full impact cutting across the income statement and balance sheet. For example, EVA increases when outsourcing decisions reduce the total sum of operating costs and capital costs. EVA also rises when the proceeds from selling a line of business, invested at the cost of capital, produces more profit than continuing to run it. Many companies find decisions like these challenging, and often reach the wrong conclusions. But EVA deftly navigates the cross currents and resolutely points to the right answers.

Besides the advantages that come from factoring the cost of capital into the profit picture, EVA widens its lead by systematically applying a set of corrective adjustments that repair accounting distortions. (Click here for a discussion of the rules and decisions these corrective adjustments include). Accounting rules mandate, for example, that companies must expense their research and development (R&D) outlays. Book profits and EBITDA take a hit when a company steps up its research budget, and they jump up when managers cut the spending—at least in the short term. These indications can be completely contrary to what is really happening.

With EVA, the approach to R&D is totally different. R&D is written off over a pre-set industry-specific period, and the cost of capital is applied as a charge to the outstanding accumulated balance (which is added to capital). That way, managers have the time needed to allow R&D investments to ripen and bear fruit, but, in exchange, they are obligated to cover the cost of capital that spreads into future periods. EVA thus better matches the cost with the expected benefit, which means it is a better measure of period-to-period progress than reported profits or EBITDA.

The same rule applies to advertising and promotion expenditures to launch a business or build a brand. With EVA, these investments are also written off over time with interest charged on the balance. EVA thus appreciates the logic in incurring upfront “costs” that can lead to a life time of customer value.

Consider one last example. With EVA, restructuring charges are added back to reported earnings and added back to capital. With that rule, EVA isn’t distorted by an up-front cost. But in exchange, EVA is burdened with an ongoing capital charge. EVA ends up increasing only if the benefits, in terms of streamlining costs and redirecting capital, exceed the cost of any new capital invested in the restructuring. EVA shows the true merits, or demerits, of a realigning the business.

All told, ISS applies more than a dozen strict rules to recast corporate earnings into a more accurate, reliable, and comparable measure of economic profit. These adjustments include treating leased assets as if they were owned (preceding by decades the new lease accounting rule), eliminating retirement cost distortions (using service cost in place or reported cost), setting aside excess cash to measure the EVA in the business, deducting taxes at a normalized rate, and recognizing the value of deferring taxes. The full range of adjustments is described in a companion memorandum, The EVA Measurement Formula.

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