The two main so-called “non-GAAP” indicators, i.e. not allowed in official North American accounting standards, are theEBITDA (as well as its little cousin the “adjusted” EBITDA) and the free cash flow. They have both become financial communication standards for listed companies.
EBITDA, a misleading measure?
The first concept of EBITDA, popularized by unscrupulous bankers during thejunk bonds” (1988-1990), yields profit conveniently restated for interest, taxes, depreciation and amortization. This operating profit is said to be “gross”, i.e. without taking into account the capital structure of the company or the long-term investment strategy.
In practice, and in the majority of cases, it is rather used by management to give an image of its performance that is much more flattering than it actually is. Indeed, except for a company with little or no capital, completely self-financed, and passing as if by a miracle between the tax collector’s nets, EBITDA generally has no relation to real profit (we realize this as soon as we compare them).
The fact that they are a so-called “non-cash” expense does not justify ignoring amortization and depreciation, in particular in the case of very capital-intensive companies, for example telephone operators or car manufacturers.
To make matters worse, listed companies now almost always resort to communications that give pride of place to so-called “adjusted” EBITDA, i.e. restated for supposedly exceptional charges such as restructuring costs, or a one-time investment. in upgrading the IT infrastructure.
For investors, pay attention to the EBITDA, or more precisely the valuation ratio EV/EBIDTAcan however be of interest on several levels:
- to identify potential acquisition targetsas companies are often valued and acquired in the private market relative to their EBITDA multiples;
- to detect potential investment opportunitiesprovided that the activity of the company is very low-capital, or that the said company has reached the end of a long cycle of investments which is coming to an end, and that it is now preparing to make a profit without investing more in its fixed assets or its growth.
Free Cash-Flow, the Holy Grail?
The second concept of “free cash-flow”, sometimes also presented under the title of “owner’s earnings”, serves to identify the company’s real earning capacity, excluding accounting entries.
In other words: how much cash profit does it generate (in cold hard currency) that can actually be redistributed to its shareholders?
To measure cash profit, focus on cash flow rather than the income statement, and subtract from cash from operations the investments required in short-term operations (i.e. in the working capital requirement) and in the longer term (i.e. in tangible and intangible fixed assets, known as “capax”).
You must then subtract from this first result the amounts invested in acquisitions, if any. We can thus clearly see how much cash has come in, how much cash has gone out, and above all to what uses these outgoings have been attributed: we can therefore calculate what is left on the table at the end of the exercise, ready to be redistributed to shareholders if necessary — this is the company’s “free cash flow”.
Once this has been identified, it is a question of understanding what the company does with these profits. Does it redistribute them in full to its shareholders? Does it pile them on the balance sheet while waiting for a transformative investment? Does it reinvest them entirely in its activity, often in addition to new fundraising? If so, for what returns on investment?
It often makes sense to look carefully at free cash flow because it is a more relevant measure of the real capacity of companies.
Two typical scenarios:
- A very capital-intensive business will produce income statements that overestimate its real earning capacity, because its real investments, the “capex” (a very emotional outflow of cash), greatly exceed the amortizations (a non-cash charge and a simple accounting entry);
- A company that has made a series of acquisitions will produce income statements that underestimate its real earning capacity because its amortization charge (non-cash charge) inherited from these previous external growth operations is greater than its actual investments.
Thus, we recommend to analyze with tweezers the data relating to EBITDA. As we have seen, these measures do not necessarily have to do with the actual earning capacity of the company. It is more relevant to seek to reconcile the accounting results and the free cash flows (aka “free cash-flows”) between them to better understand the nature of the activity and its real profitability. Indeed, what interests us is the volume of cash generated for shareholders which can then be redistributed as dividends, used for share buybacks or reinvested in the business to ensure its growth via external acquisitions or organic developments. Here, you now know a little more about the difference between GAAP and non-GAAP.