The smart money saw this coming in late 2021. In particular, hedge funds and growth equity firms that saw the top blowing off public market equity valuations after the Fed signaled a 180° turn in monetary policy. The Fed’s dramatic redirect toward accelerated tightening resulted in jacked-up interest rates and the siphoning off of systemic liquidity through attenuated US Treasury purchase roll-overs. Within this new economic paradigm, a thirteen-year period of heavy money flows into risky assets came to a crashing halt, and with it, one of the more popular tenets of investing in the same, ‘growth-at-any-cost’ a.k.a growth without free cash flow (FCF). And now, as one would assume would happen with this change in investor mindset, the financial analysis of risky assets has changed in how it weighs the value of the metrics that underpin it. One of the most notable has been the dismissal of EBITDA – once, the end-all-be-all lever of enterprise value (EV), financial analysis, valuations, and deal making – and its replacement with sister non-GAAP financial metric free cash flow. The indictment against EBITDA, or in the great words of Berkshire Hathaway’s Charlie Munger, the ‘bullshit’ financial metric, lies in its inability to clearly see a company’s actual cash position in a given time frame. And there are valid reasons to support why this is in fact true. But, what’s more important now is that owners and operators understand, and learn to accept (quickly), that FCF is now firmly in the driver’s seat, and it alone has become the determining factor in not just EV, but literally, whether an ongoing concern is investable at all. Thus, for owners and operators who are diligent about monitoring their business’ valuation, it would be prudent and timely to get a handle on their FCF situation – what they can do to increase it, and how they can avoid negatively impacting the same. As the goals of management should always consider value creation, it’s critical to understand, especially in a down economic cycle, that the ‘adults in the room’ – venture capital, private equity – are looking at FCF to determine valuation. And EBITDA? Well, it’s for kids.
By my reckoning, EBITDA’s underpinning of enterprise valuations had a good run. Very much in line (durationally) with the low Federal Funds Rates between the Great Financial Crisis and the end of 2021. And therein, perhaps, resides the rationale for EBITDA’s sudden demise. If it is assumed we’ve begun the downward slide into the trough of a boom-bust cycle, an economic cycle characterized by high interest rates, tight credit, less borrowing, and certainly less capital flow to riskier asset classes (private and public equities), then we can also assume – don’t have to assume, actually, we’re already seeing it – that capital deployment now flows within a framework of heightened scrutiny. The consequence of which, when contemplating enterprise investment and/or acquisition, manifests itself in the need for a clear and accurate portrayal of a company’s real-time cash position, hence the coronation of FCF, and the subordination of EBITDA, which doesn’t take into account a time period’s outflows for capital expenditures, changes in net working capital, nor the tax consequences of what’s left over. This is particularly true for investors and acquirers who use leverage for deals, because they need to know exactly how much cash is available to service debt. EBITDA does this too, but not with the same degree of accuracy, nor does it address the tax liability on the cash flow from operations.
One thing that this new paradigm shift is not, is a reason for owners to panic. It’s simply the natural evolution of thought of rational investors, mainly financial sponsors of the private equity sort – the FCF/EBITDA issue has much less to do with valuations driven by strategic value – who no longer have any wiggle room to be slightly off on the amount and type of consideration paid in a transaction. They’re success, as measured by their ability to raise more capital, is tied to their history of having met or exceeded the Return on Investment or Internal Rate of Return they committed to provide to their Limited Partners.
Takeaway?
The takeaway here, then, is neutral. That EBITDA is no longer a key lever of the economic value of a company, and that FCF is, is neither good nor bad. It’s simply the new reality. And the notion that, well, ‘EBITDA is for kids’ might sound silly? One ought to take note of investor eye-rolls, now, if presenting an opportunity that leans on EBITDA instead of FCF as the headline financial metric. Understanding and accepting that it’s now through the FCF lens, executives can better plan, manage, and position their businesses to capture maximum value when the need or desire for a capital event next occurs.
