Cash Flow Is Superior to EBITDA

Free Cash Flow Is Superior to EBITDA

Published on:
July 28, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

It took over ten years for people to get used to the idea of an automatic elevator; over 30 years to feel okay about eating shrimp [1]; and 20 years passed before passive investing, tracking the movement of an index such as S&P 500, was accepted [2].

This essay reflects whether it is time that we change how we look at the
operating performance of a business.

What's wrong with EBITDA

Earnings before interest, tax, depreciation and amortization (EBITDA) allows management to boast on theoretical, imaginative financial results. It is similar to a marathon runner explaining that he or she finished a marathon in less than four hours, if only they had not taken a 25-minute rest in the second hour. 

EBITDA figures are always higher than free cash flow numbers and result in a higher valuation for the company and a greater ability to take on debt. It should be of little surprise that it was popular in the ‘80s - the era of leveraged buyouts.

Net earnings are suspicious too. This is because management is acutely aware that Mr. Market [3] watches net earnings like a hawk. In addition, net earnings are subjective because expenses such as depreciation, goodwill and amortization  are dependent on management decisions. As a result, it is hard to compare the net earnings of one company to the next. 

EBITDA numbers are higher than net earnings. Little surprise they are popular in leverage buyouts.

While net earnings are influenced by management’ decisions, reported book value measurement is dependent on the accounting convention. And while intentions may be innocent for both the accountants and management, the reported book value often results in nonsensical numbers for the investor.

Consider goodwill as an example. This asset category represents the excess purchase price above the net fair value of the company acquired. While it is considered an asset, the chances the reported value will be realized is as real as the chances that another purchaser will price the goodwill account as reported on the balance sheet. That rarely happens.


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Free cash flow definition

The classic definition of free cash flow is cash flow from operations less capital expenditures. provides guidance how to calculate free cash flow. With free cash flow, it is easier to compare the profitability of a real estate firm to a company that sells dairy products.

Both companies collect and spend cash and both companies require cash to maintain their operations. A real estate company will repaint the buildings it owns and a dairy products company will upgrade the manufacturing plant. For the investor, in both scenarios, there is really only one concern: how much cash will be left at the end of the day.

Free cash flow provides the true picture of how a business is doing. Free cash flow aims to answer one question: how much cash is left to the owner of the business after all required expenses and taxes have been paid.

If we can estimate how much cash flow a business will generate in the future, we can decide whether the current price of the stock fairly represents the expected future cash flow. (There are other uses of free cash flow. credit issues. Read on the importance of free cash flow here.) While this is a simple, fundamental concept to stock investing, it is also one of the hardest ones.

It is hard because the future is unknown, and because the future
economics of a company are dependent on many immeasurable variables.

Consider the case study below where I describe a company that sells dairy products. Its profitability is dependent on a consumer's preference; on the cost of raw milk; on changes in the competitive landscape; and on its distribution system and manufacturing capabilities.

Free cash flow example

Observing free cash flow was the reason why I bought the stock of Lifeway Foods (LWAY) a few weeks ago. Between 2017 and 2008 the company earned a total of $32 million.

But the reported earnings included $22 million of depreciation expenses. So I added those back. I also removed capital expenditures [4]  and the working capital expenses (such inventory). These were $38 million. The result was that Lifeway earned a total of $17 million in free cash flow over the past decade.

I estimated that over the next ten years the company's free cash flow will be $17 million too. And so we can say that on average the company's free cash flow each year will be $1.7 million.

(For simplicity sake, I assume no change in shares outstanding and used the current number of 16 million shares in my calculations.)

At the price of $4 a share, I bought $2 of tangible book value and an expected ten cents per share of free cash flow over the next decade. Grab your HP12C, and you will find this is an expected free cash flow yield of 10%.

[1] Shrimps were considered the ocean’s cockroach. 
[2] In the ‘90s passive investing was said to be "unAmerican."
[3] Mr. Market is an allegory created by investor Benjamin Graham. It was first introduced in his 1949 book, The Intelligent Investor.
[4] capital expenditures is reported in the cash flow statement, not in the income statement.
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