What began as a tool for normalizing and comparing results has become a tool for valuation engineering
Over the past decade, the use of adjusted EBITDA metrics has spread exponentially among listed companies and in the private equity world. What began as a tool for normalizing and comparing results by removing clearly non-recurring effects has become a tool for valuation engineering and leverage. Adjustments have moved from removing one-off expenses and distortions to anticipating future improvements and treating projections as if they were historical data, diluting economic rigor.
The creativity of these adjustments is pushing these metrics further away from both accounting profit and real operating cash flow. This excess optimism can significantly damage the reputation of listed companies. The ever-growing adjusted EBITDA often does not translate into real cash in the future.
The line between reasonable adjustments and optimism is becoming increasingly blurred. At some point, adjusted EBITDA becomes fictional EBITDA.
Adjusting the truth
According to PitchBook, these adjustments account for up to 30 percent of adjusted EBITDA, compared with levels of close to 10 percent that were common a decade ago. In the latest S&P Global study on M&A, adjustments represent around 28 to 29 percent of adjusted EBITDA. Most of these adjustments are concentrated in categories such as projected synergies and cost savings (which are difficult to fully achieve), followed by transaction costs, restructurings, ‘non-recurring’ operating expenses and management compensation normalization.
These adjustments increase the adjusted EBITDA figure. This makes companies’ leverage multiples look lower and therefore allows them to raise more debt, which the future adjusted EBITDA is expected to support. Data from another S&P report show that actual leverage is much higher than expected. The median debt to EBITDA ratio is 2.3x above projections after one year and 2.7x after two years.
Another consequence is higher valuations in company sale processes. A €15 mn ($17.5 mn) upward adjustment can increase valuation by €150 mn if the company is valued at 10x EBITDA. Conversely, the buyer may argue that they are paying less for the company, since the multiple paid on the upward-adjusted EBITDA will always be lower than on the pure accounting result.
One way to inflate EBITDA and move it away from real operating cash flow is by including extraordinary or non-recurring items as accounting revenue, such as gains from asset sales. It is true that under current accounting rules these amounts must be reported within operating profit (EBIT), one level below EBITDA. Failing to identify them separately can confuse investors.
In many cases, these items are included under ‘other income’, which in some companies can represent 5 to 7 percent of sales. This means that an item that is, by nature, an investment-disposal cash flow becomes part of operating flows.
There may even be cases where such items include non-cash concepts, such as reversals of long-term provisions previously recognized as expenses, or other asset valuation adjustments that do not directly arise from a divestment transaction. A footnote buried in the notes will explain it, but probably no investor will read it.
Higher margins
This accounting flexibility allows companies to boast about a higher consolidated EBITDA margin, since it is calculated on sales rather than total income. The problem is that this higher EBITDA can be far removed from operating cash flow. Both PitchBook and S&P report that only 8 percent of the companies analyzed achieve this ‘marketing EBITDA’ after one year. According to the cited study, after two years reported EBITDA is 32 percent below projected EBITDA, based on 280 companies analyzed.
Investors have limited time and many companies to analyze. Frequently, they rely more on PowerPoint sales presentations than on audited reports. Those are 400-page documents that are hard to digest, especially if you have 60 companies in your portfolio.
The creativity of these adjustments is pushing these metrics further away from both accounting profit and real operating cash flow.
Real operating cash flow can be calculated indirectly from net income or directly through receipts and payments. It is a regulated calculation included in audited financial statements.
In recent years, the number of companies presenting this calculation to investors has skyrocketed, starting from EBITDA or adjusted EBITDA and subtracting changes in working capital, interest, and taxes. This has led to ‘PowerPoint operating cash flow’ (or ‘adjusted operating cash flow’), which in many cases differs significantly from real operating cash flow.
Gaining credibility
One way to gain credibility with investors would be to include this calculation method in the annual management report and, if that operating cash flow does not match the figure reported in the financial statements, provide a clear reconciliation between both numbers.
In fact, the currently applicable rules on Alternative Performance Measures (APMs) require listed companies to explain why they use these measures and reconcile them with official metrics. This explanation must form part of the management report, which is reviewed by the auditor (though not audited like the financial statements) and signed by the board of directors.
For listed companies, managing EBITDA is not just a technical issue, but one of credibility in the eyes of the market. When a listed company repeatedly reports adjusted EBITDA that is far above operating cash flow, investors eventually detect the gap: they see it in the debt profile, in free cash flow per share, and in the need for capital increases, unexpected refinancings or the full or partial sale of assets or business divisions.
In the medium term, trust in management deteriorates. The market usually penalizes companies perceived as ‘EBITDA engineers’ more heavily. Analysts begin to discount official figures, apply multiple discounts and demand higher risk premiums. Investors stop spending time on them and usually end up removing these companies from their portfolios.
Ricardo Jiménez Hernández is strategic adviser at Harmon and a former director of investor relations at Ferrovial. He is also a member of the IR Impact editorial board
