One person has been reading our blog on EBITDA on LinkedIn several times, or several people have found it fascinating. That blog has generated the most “impressions” among recent ones.
Since Elon Musk launched his bid for Twitter, EBITDA, earnings before interest, taxes, depreciation, and amortization have entered the popular press. As a result, we are watching in real-time how the market values businesses.
A real-world example has helped us support why we use the loss of “free cash flow” as a legitimate way to value the loss of business in damages cases.
“Free cash flow” allows investors and lenders to determine whether, based on their risk appetite, how much a venture is worth. As a result, several business services like BVR generate EBITDA multiples across industries.
In the case of Twitter, the market places the business’s value (the selling price) at 6x the EBITDA. In early news reports, Musk would be offering 12x. However, according to recent BVR data, the average “selling price to EBIDTA” is about 4x across all industries.
The concept of “free cash flow” as a business valuation tool is also helpful in small business loss cases where the firm’s value doesn’t depend on its market value.
The amount of “free cash flow” that is available gives the small business owner or the owner-worker a measure of how much money they have to apply their “magic sauce.”
But, of course, Musk is not the only entrepreneur that knows how to “unlock value.”
The loss of “free cash flow” is the “loss of the capacity” of a small businessperson “to do their thing” – to release the value of their businesses.
What about depreciation?
We get this question the most in our business loss forensic cases.
Keep in mind that the purpose of a business is to create value, whether the firm is Twitter or Apple or a small business. EBIDTA is an indicator of how well the company is succeeding at that.
While “depreciation” is a component of the “profit and loss” or “income statement,” it has nothing to do with the operation of the business.
But doesn’t the firm need capital equipment to operate?
Yes. However, we reflect capital expenditures on the firm’s “balance sheet.” We expense it on their “income statement” based on tax and depreciation guidelines.
Depreciation expenses don’t affect the operation of the business. That’s why they don’t reduce “free cash flow.”
What about amortization?
Like depreciation, “amortization” is set independently of the operation of the business. Taxing and regulatory bodies set the amortization rates.
Yet, again, amortization doesn’t affect the core business operations. Therefore, we don’t use it to reduce “free cash flow.”
What about interest?
Interest, like depreciation and amortization, influences the firm’s profitability, not its operations.
What about dividends?
A company pays dividends out of profits.
Dividend payments or stock buybacks will depend on the firm’s goal to maintain the value of the stock. A firm most likely will have a “stock valuation policy” like a tax minimization or debt servicing one. While these policies are essential to the business, they don’t affect the value-creating activities of the core business activities.
What is “free cash flow” good for?
“Free cash flow” allows management to do various things.
1. To invest in the business.
This is the number one use of “free cash.” It’s the amount of money management can use to maintain and grow the business – to increase the value of the business.
2. To meet tax liabilities.
A company may have a “tax minimization strategy,” to reduce cash outlays. But, again, the amount of taxes due doesn’t affect the core business. In addition, there are frequent news reports of firms paying no taxes.
3. To service debt.
This is one of the main issues in the Musk-Twitter articles.
How much debt can Twitter take on?
In this case, “free cash flow” is a measure of the capacity of the firm to pay bondholders. However, it’s not saying that we should use debt servicing to reduce the amount of free cash available to the firm.
Debt-serving is not a core business activity. Musk’s bet is that he can manage Twitter in a way that increases its “free cash flow.”
Firms will have a “debt servicing policy” that minimizes servicing costs while preserving their cash.
4. To pay dividends.
Net profit will determine the amount of money the firm will have available to return to the equity holders. In another blog, we discuss the distinction between total revenue, free cash flow, and net profit.
Here’s another critical point. Paying a dividend may not be a positive use of funds. Why? Because paying a dividend may signal to investors that the company doesn’t have a higher return investment to make in the business. That’s not a good signal.
Again, these are examples of the uses of “free cash flow.” But, taxes, debt service, and dividend payments are not offsets against it. Depreciation and amortization, tax, and debt servicing policies are important, but they don’t affect the operation of the core business, which is to increase value.
There’s a business adage that says: “cash is king.” The sources and uses of “free cash flow” are why that adage rings true.