E.B.I.T.D.A.: A Lesson in Non-GAAP Measurements
E.B.I.T.D.A.: A Lesson in Non-GAAP Measurements
We break down this financial metric to its core elements, examining why it is the preferred option for investors and lenders, and why regulators are skeptical.
Earnings before interest, taxes, depreciation, and amortization (EBITDA), perhaps the most inelegant of acronyms, is a term seen in documents everywhere, from investment banker memorandums to creditor agreements to stock compensation awards to public filings with the Securities and Exchange Commission (SEC). Take earnings and add I, T, D, and A. Seems simple enough, right? While EBITDA can be a useful tool for measuring a company’s normalized financial performance, its derivation is open to interpretation.
E Is for Earnings
We begin with earnings, or more specifically, net income as reported according to generally accepted accounting principles (GAAP). Net income is defined in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 205-10-20 as “a measure of financial performance resulting from the aggregation of revenues, expenses, gains, and losses that are not items of other comprehensive income.”
As equity holders are the residual claimants on a company’s value, net income (or loss) reflects the residual claims on a company’s profits, after considering the expenses necessary to generate those profits from an equity holder’s perspective.
GAAP-basis net income is the standard definition of corporate profits. Still, companies and their investors have devised alternative non-GAAP measures they believe may better explain or simplify financial performance, earnings, and cash flows. EBITDA is the most frequently used such measure. At its core, EBITDA reflects net income before two types of adjustments:
- Normalizing adjustments, which are intended to increase the comparability of successive periods (e.g., year-over-year growth or profits) or between companies (e.g., for different capital structures or special tax situations)
- Noncash adjustments, which are intended to approximate the cash flow-generating capacity of a business by excluding items of income or expense that are solely accounting-based in nature
The calculation of EBITDA may be explicitly defined and governed by legal agreement, such as a credit agreement or an equity incentive plan. Even so, we have found that such definitions are often open to broad interpretation, particularly as it relates to nonrecurring charges.
I Is for Interest
Investors and valuation professionals alike frequently determine a company’s value on an enterprise basis. Enterprise value represents the total invested capital of a business, including common and preferred equity and interest-bearing debt. To determine value on an enterprise basis, we must also measure financial performance on an enterprise, or “debt-free,” basis by adding back interest expense.
The “I” in EBITDA may also pertain to interest income on cash and investments. If cash and investment balances are viewed as financing decisions, and their value is captured independent of the company’s cash flows, it is also appropriate to exclude interest income from EBITDA.
T Is for Taxes
Effective income tax rates can be highly variable from year to year and between companies due to book versus tax basis differences; net operating loss carryforwards; local, state, and federal tax credits and subsidies; multinational operations; and other tax-efficiency strategies. Moreover, depending on the purpose of a particular financial analysis (e.g., measuring a company’s value in the context of an asset transaction), existing tax attributes may not transfer to a buyer. Adding taxes back to net income as a normalizing adjustment helps mitigate these differences, provided that the specific tax attributes of the subject company are considered separately.
In addition, adding interest, depreciation, amortization, and other adjustments to net income would require a recalculation of a company’s reported income tax expense. Adding taxes back eliminates the tax impact of these adjustments.
D Is for Depreciation
Book-basis depreciation reflects an attribution of cost for previously acquired tangible assets. In addition to being noncash, depreciation is added back to normalize varying levels and timing of capital investment between companies.
The case for EBITA, or for EBITDA less normalized capital expenditures
Depreciable assets are “wasting” in nature; that is, they wear out. While depreciation is a noncash expense, it represents the economic use of an asset that will likely require replacement in the future. We can capture replacement capital expenditures in a discounted cash flow (DCF) model, but analyzing valuation multiples or credit capacity on an EBITDA basis does not readily lend itself to such discrete measurement.
In an increasingly intangible economy, fixed assets may be insignificant. However, in capital-intensive industries, an overreliance on EBITDA as a cash flow proxy can be misguided. In these scenarios, we may consider a company’s earnings before interest, taxes, and amortization (EBITA) in addition to EBITDA, to identify the most consistent and indicative pricing relationship, wherein depreciation is used as a proxy for the ongoing capital replacement requirements.
Perhaps a better measurement is EBITDA less normalized capital expenditures. This metric normalizes varying levels and timing of past capital investment while also capturing the cash outflow required to sustain continued operations. In this vein, credit agreements often contain financial covenants calculated on an EBITDA basis, but with a cap on capital expenditures, subject to lender approval.
A Is for Amortization
Like depreciation, amortization addbacks are noncash and normalizing adjustments. Unlike depreciation, however, amortization is usually recognized only if the business was a party to an acquisition. Definite-lived intangible assets (e.g., certain trademarks, developed technology, customer-based intangibles, noncompete agreements) are amortized over their remaining useful lives, and indefinite-lived intangibles (e.g., certain other trademarks, goodwill) are held at their original acquisition cost, and then tested for impairment at least annually.
While we strongly believe in the informational value of recognizing and amortizing the cost of acquiring intangible assets, the business combination accounting rules can create material differences in reported profits. Imagine a business that grew organically, and then is acquired at the end of 20X1. Even if that business’ performance is identical in 20X1 compared with 20X2, its profits in the year after the acquisition will be significantly reduced as a result of amortization expense, though its value or credit capacity is not materially different.
Outside of a business combination, capitalized development costs may also be amortized. Most organic growth-oriented costs are expensed as incurred. However, current GAAP provides for the capitalization and amortization of certain development costs, and accounting-standard setters are evaluating an expansion of what costs can be capitalized in an effort to recognize the value of internally generated assets on a company’s balance sheet.
On the one hand, the expensed-as-incurred model most closely attributes the cash cost of a business’ operations in the period incurred. On the other, that company may benefit from the asset generated from the development efforts for years to come (not unlike acquiring a tangible asset), and may be able to reduce future development costs when the current project reaches scale. In that case, the capitalization-and-amortization model may best represent a company’s growth investments, by coordinating the timing of revenue and expense recognition.
In a world where EBITDA is king, however, one cannot ignore the attraction of recharacterizing an expense as a capitalized item. Converting research and development costs from a period expense to amortization results in a direct, dollar-for-dollar increase to EBITDA, without changing the cash outflow of the investment. It can be argued that this method of expense recognition more accurately reflects the value being generated by the research and development effort. It can also be viewed as nothing more than earnings manipulation.
Interest, taxes, depreciation, and amortization are only the beginning. Adjusted EBITDA goes one step further in regard to normalization and noncash adjustments, requiring additional judgment and discretion from management. Frequent adjustments to EBITDA include:
- Stock-based compensation
- Restructuring and other one-time charges
- Gains and losses
- Foreign currency translation adjustments
As reported in The Wall Street Journal, regulators recently flagged buyouts of Ultimate Fighting Championship, Cvent, and SolarWinds for potentially aggressive or unsupported adjustments to EBITDA. In one example, SolarWinds reported unadjusted EBITDA of $178 million compared with adjusted EBITDA of $322 million in reports to its creditors. The largest adjustment of $54 million related to an addback of stock-based compensation expense.
The magnitude of these adjustments may seem untoward. Still, their appropriateness hinges on the circumstances and nature of the adjustment.
ASC Topic 718, Compensation – Stock Compensation (ASC 718), and International Financial Reporting Standards (IFRS) No. 2, Share-Based Payment (IFRS 2), provide that an entity is required to measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award as of the grant date. That cost is then recognized over the period during which the employee is required to provide service in exchange for the award (typically, the vesting period).
The accounting goal of expensing stock-based compensation (SBC) is to capture the aggregate cost of employment, including cash, stock, options, and other benefits. Although these awards may be noncash in nature, an employee’s full compensation package must be recognized.
It is also the objective of a valuation professional to understand and account for the full cost of compensating a company’s employees, either by including SBC as an expense, or by removing SBC and then accounting for the dilutive impact of the unvested securities through equity allocation techniques. Thus, the appropriateness of adding back SBC to EBITDA, or of including this expense as a deduction to earnings, depends on the valuation approach or approaches employed, provided that dilution is addressed and consistency is maintained with regard to the valuation inputs, outputs, and methodology.
Lenders tend to be less interested in the dilutive impact of securities subordinated to debt. Their focus, instead, is on the capacity to service the debt obligations through cash flows. Thus, noncash addbacks for SBC can more accurately present the cash flow-generating capacity of a business to repay its debts. In the SolarWinds example previously cited, though the SBC adjustment was large, we would argue it was wholly appropriate for reporting to the company’s creditors.
Restructuring and other one-time charges
Restructuring and other one-time (ROOT) charges are the most subjective of all EBITDA adjustments. Companies rationalize ROOT adjustments on the basis that these one-time cash expenses are not indicative of normalized operations. From a valuation or lending perspective, this is reasonable and appropriate. But what is recurring versus nonrecurring? A skeptical outsider might contend that companies expand the definition of “nonrecurring” in an effort to boost adjusted EBITDA, picking up “recurring nonrecurring” items (e.g., litigation expenses in an individual case may be unusual, but responding to lawsuits is a necessary cost of business).
The SEC recently issued an updated Compliance & Disclosure Interpretation (C&DI) regarding non-GAAP financial measures, which contained the following:
Question: Can certain adjustments, although not explicitly prohibited, result in a non-GAAP measure that is misleading?
Answer: Yes. Certain adjustments may violate Rule 100(b) of Regulation G because they cause the presentation of the non-GAAP measure to be misleading. For example, presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business could be misleading.
Furthermore, Item 10 of Regulation S-K and Item 10 of Regulation S-B prohibit the following:
Adjusting a non-GAAP performance measure to eliminate or smooth items identified as nonrecurring, infrequent, or unusual, when 1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or 2) there was a similar charge or gain within the prior two years.
Gains and losses
Gains or losses are noncash income or expenses that arise when assets or liabilities are sold or settled for an amount different from their book or carrying amounts. These are typically nonrecurring transactions that are appropriately removed from EBITDA to normalize results.
Foreign currency translation adjustments
Foreign currency translation adjustments arise when local or functional currencies are translated to an entity’s reporting currency. While these noncash charges are usually appropriate to present a company’s normalized operating results, one must not ignore the informational value of significant translation adjustments in terms of foreign currency exposure risk.
 Just as net income does not include a deduction for dividends to equity holders, it also does not include a deduction for principal payments on debt. Accordingly, adding back interest expense, net of the tax impact, results in debt-free net income.
 In the United States, tax-basis depreciation is typically accelerated relative to book-basis depreciation. Accelerated depreciation for tax purposes has long been a tool used by legislators to spur capital investment by allowing for a faster deduction of the cost of such investments.
 Under U.S. GAAP, Accounting Standards Update (ASU) No. 2014-02 and No. 2014-18 provide that certain nonpublic entities may elect to amortize goodwill and not recognize certain customer-based intangibles and noncompetition agreements.
 Liz Hoffman and Matt Wirz, “The Ultimate EBITDA Fighting Championship,” The Wall Street Journal, October 16, 2016.
 “Non-GAAP Financial Measures,” U.S. Securities and Exchange Commission, last updated May 17, 2016.
 “Final Rule: Conditions for Use of Non-GAAP Financial Measures,” U.S. Securities and Exchange Commission, effective date March 28, 2003.