👋 Hi, it’s CJ Gustafson and welcome to Mostly Metrics, my weekly newsletter where I unpack how the world’s best CFOs and business experts use metrics to make better decisions.
EBITDA and FCF are often used interchangeably in the context of profitability. Both drop out of the bottom of your P&L, and are linked to company valuation. But similar to how olive oil and sun tan oil are both oils, you can eat one, while the other is only for superficial purposes.
What the hell do I mean?
If I were to sum it up, EBITDA is used to compare companies on the surface, while Free Cash Flow can be consumed. Let’s dig in.
EBITDA
EBITDA (earnings before interest, taxes, depreciation, and amortization) is as if the playing field was equalized for where a company is located and its choice of debt vs equity financing. In a vacuum, and at full speed, what could I get out of this thing?
EBITDA is like comparing runners on a perfectly level and controlled track. It doesn’t matter if they trained at high altitude or sea level, in hot or cold conditions; on race day, everyone competes under the same, ideal conditions. This helps compare their pure running capabilities without external factors.
Here are EBITDA’s core characteristics, and why investors rely on it for decision making:
Removes debt financing decisions from the equation
It removes the impact of debt by adding back Interest, allowing you to compare companies regardless of their capital structures
FCF penalizes you for debt financing.
Levels the playing field for local tax treatment
EBITDA puts companies on a level playing field as to where they choose to conduct business
Uncle Sam collects his toll from FCF
Neutralizes for the impact of capex decisions
EBITDA doesn’t care if you rent a machine or buy it outright
FCF realizes that data centers don’t grow on trees
Strips out some bad management decisions for comparability
Related to what we’ve already mentioned, since EBITDA cuts through financing and tax nuances, it removes some of the noise that could be caused by bad management.
FCF gives you no mulligans for bad strategy
Used more frequently in industry benchmarking
Due to it’s comparative nature, companies can compare their EBITDA margins against industry averages to gauge their performance.
FCF will be prone to Apples to Oranges comparisons
Net net, EBITDA helps to make companies comparable to one another.
I’d be remise to note that EBITDA is a non-gaap metric. That means it won’t show up in normal financial statements. You need to do some math to back into it.
Free Cash Flow
Free Cash Flow is like looking at how much produce you have left after a season of gardening, considering all the money and effort spent on seeds, tools, and maintenance. It tells you how much actual, tangible produce you can enjoy, sell, or save for the future. Unlike EBITDA, which shows potential yield, FCF shows what you can truly harvest and use.
In my opinion, it’s a much more honest assessment if you are an operator who’s in it for the long haul.
Here are FCF’s key characteristics, and why operators rely on it for decision making:
Measures a company’s capacity for taking on (and paying down) debt
If an investor is financing the acquisition of a company with debt, they’ll need to consider the company’s ability to service it
EBITDA would tell you to lever that puppy to the gills
Better for forecasting growth, or dividends
After paying down its debt, a company can either reinvest that cash into the business to fuel more growth, or give it back to their shareholders
EBITDA is much less helpful for this type of planning
Focuses on total financial health
FCF identifies if you are buying a company that is asset rich, but cash poor
EBITDA could obscure cash crunch concerns
A better measure of stability
Investors often look at FCF to assess the stability and predictability of cash flows, which is crucial for companies in capital-intensive industries.
Investors often look at EBITDA for financial engineering
Similarities
Both remove non cash mumbo jumbo
Depreciation and Amortization
Stock based comp
Both are bottom line valuation measures
Enterprise Value / EBITDA
Enterprise Value / FCF
Summary:
Focus: EBITDA focuses on a company’s core operational profitability, while FCF focuses on cash generation after capital expenditures.
Exclusions: EBITDA excludes interest, taxes, depreciation, and amortization, while FCF includes capital expenditures and changes in working capital.
Application: EBITDA is often used for comparing operational efficiency and valuing companies, whereas FCF is used for assessing liquidity, debt serviceability, and sustainability of cash flows.
If I were a private equity investor looking to compare companies I might hold for five years, I’d use EBITDA to understand their operational efficiency. If I were an operator looking for confidence in my company’s profit capacity and cash availability, I’d rely on FCF.
Neither is inherently better - you should be calculating both to see how you compare to others, and how you measure up to your own internal expectations.
Bonus: Real-World Scenario:
Scenario: An investor is evaluating two companies in the telecommunications sector: TelcoA and TelcoB.
TelcoA: Shows high EBITDA, indicating strong operational performance. However, its FCF is low due to significant capital expenditures on upgrading its network infrastructure.
TelcoB: Has moderate EBITDA but strong FCF, as it has already completed major capital investments and is generating substantial cash flow from operations.
Analysis:
EBITDA Perspective: The investor sees that TelcoA is efficient in its core operations but needs to understand the impact of its capital expenditures.
FCF Perspective: The investor finds that TelcoB is generating strong cash flow, which can be used for dividends, debt repayment, or further investments without needing additional financing.
Decision: Depending on the investment strategy:
Growth Focus: The investor might lean towards TelcoA, betting on future profitability once capital expenditures decline.
Income Focus: The investor might prefer TelcoB for its strong FCF, indicating a stable and sustainable cash-generating business.
Next week we’ll be back to cover the differences between Renewal vs Retention.
