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Commonly Confused Metrics: EBITDA vs Free Cash Flow
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Commonly Confused Metrics: EBITDA vs Free Cash Flow

Our July series on commonly confused metrics

CJ Gustafson's avatar
CJ Gustafson
Jul 11, 2024
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Commonly Confused Metrics: EBITDA vs Free Cash Flow
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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.

Explain It Season 5 GIF by The Office

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

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