Why EBITDA is better than growth

The most common objective shared by countless entrepreneurs and corporate executives is growth: boosting sales, broadening the customer base, expanding the product range, and breaking into new markets, perhaps by setting up new subsidiaries.

If we take the growth path of some companies and put it on a map of the world, we may end up with what looks like the board game Risk: to win you have to advance with your little tanks, adding more and more to your army, and plant your little flags to conquer as many countries as you can.

But the problem is that this kind of growth path does not always guarantee higher value of the company or greater satisfaction for shareholders.

Take the airline industry, for example. Often, we refer to it as one of the industries where companies did grow, adding production capacity and increasing invested capital to do so. But what they didn’t do was to secure a sufficient return on these new investments. In the end, the value of these airlines inevitably shrunk. The companies in this industry would have done better not to grow, and instead to focus on boosting the profitability of already up-and-running activities.

We can find a similar outcome for companies that opt for external growth, i.e. growth through acquisitions. In these cases, often the price paid to buy the target company was what triggered a decline in the share price of the parent company. One of the most famous international cases was the acquisition of WildHorse Resource Development by Chesapeake Energy, a natural gas company. The four-billion-dollar deal ended up sending the buyer’s share value into a downward spiral of losses; Chesapeake ultimately filed for bankruptcy.

The problem is, it’s not enough to grow – companies have to find the right way to grow. But if that’s not possible, for instance in industries that typically have excess production capacity (a few examples that come to mind are cured meats, or some sectors in the publishing or energy industries). In such circumstances, growth at all costs, investing or acquiring companies at any price, could well turn out to be a solution that’s worse than the problem.

So growth for growth’s sake is not necessarily a good thing: growth is good if it increases the value of the company, and bad if it does the opposite. But how do we now if growth will drive up value? First of all, we have to use an assessment criterion for companies and for each company decision based on the value - and not on the size or the turnover – of the company.

For many years, attention has centered on the value of the company, and since the ‘90s this has gone hand in hand with focus on the EBITDA, a performance indicator that more recently has made it to the hit parade of entrepreneurs and corporate executives alike.

So forty years ago everyone was talking about EBIT, or operating income. But again since the ‘90s, EBITDA has become the more popular buzzword. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization, so clearly this doesn’t factor in the value of depreciation and Amortization (unlike EBIT). But that’s not the real reason that EBITDA is such a hit. Instead the reason is that EBITDA is the most common parameter used in valuing companies, in particular in the context of M&As.

Forty years ago, countless companies were valued and sold based on their net profits: many entrepreneurs will remember that ‘back in the day’ when they sold their companies, the price was based on a valuation calculated as ten times net profits. For over one hundred years, one of the most famous formulas in the world of finance linked the share price to earnings per share: share price = P/E ratio x earnings per share.

We use a similar formula today to value companies based on EBITDA: company value = EBITDA multiplier x EBITDA.

Many entrepreneurs wonder what the value of the multiplier is for their industry or their company, as if it were some sort of magical number. The better informed among them access data banks (for instance Damodaran) and discover that the multiplier for different industries differs: steel is lower than food which in turn is lower than software. Often, they ask themselves the reason behind these differences.

The multiplier encapsulates all the critical components of the value of a company in a single number: the prospects for growth, the potential for risk, the need for capital and - last but not least - the bargaining power of the parties involved in a possible M&A. At the same time, the method is based on real data: starting from EBITDA and the value of comparable companies (listed companies, or companies acquired in similar deals), the multiplier is then calculated by working backwards, dividing the value by the EBITDA. It’s not a magic formula, but it is a clear one. Many entrepreneurs and corporate executives understand this concept and manage to share what they know with their collaborators.

And this is the crucial point: instead of striving to grow simply for the sake of growing, the common language of entrepreneurs, corporate executives, and company employees at every level should be EBITDA and the value of the company. This is the essential element in setting goals and steering decisions, not to mention evaluating performances and remunerating collaborators.

When a company succeeds in doing all this, what changes are work practices. And revamped work methods in turn are what drive changes in results. From the head of the company to the management team, and from these company leaders to their collaborators, goals are identified and assigned in a logical way. People are no longer interested in launching a new product or opening a new branch if they can’t find a way to link these initiatives to an increase in EBITDA and the value of the company. And that’s not all. People know from the start of the year how they will be evaluated and what they need to do to get their bonus. Lastly – and this is what matters most –the system of goals of management aligns with the goals of company owners.