Free Cash Flow vs. EBITDA for Investment Performance

How Can an Investor Determine ROI?

How do you measure your investment’s performance? If the company is doing well, does that mean your investment is doing well? When it comes to free cash flow vs. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is the better performance measure?

Return on investment (ROI) is the sum of all cash payments received plus any appreciation in the market price (today’s selling price, less purchase cost), divided by your cost. For example, if I bought at $50/share on January 1, received $1.50/share in dividends during that year, and sold at $54/share one year later, my return of $5.50 equates to an 11% ROI.

That same principle can be used to measure the performance of a company. Take the aggregate market value of the company’s equity at the beginning and end of the desired measurement period, plus any cash distributions during the period divided by the market value at the beginning. This is the conceptual basis for Total Shareholder Return (TSR), a popular and useful metric to measure company performance for investment decisions and executive compensation schemes.

Converting TSR into an annualized rate of return becomes an excellent comparative metric for investment decision-making and measuring company performance relative to its peers. Using the same TSR as above, except that the appreciation occurs over 18 months, the annualized rate of return is ($5.50/$50.00)^(18/12) = 3.65%. The annualized rate of return can be compared to the market-required rate of return and/or other potential investments.

There are other metrics that are often considered when evaluating company performance. Some are based on generally accepted accounting principles (GAAP), such as net income (NI) and earnings per share (EPS). Some are considered ‘non-GAAP measures’ because their calculation is not defined by GAAP. Non-GAAP measures are being reported in public company annual reports more frequently because of the increasing popularity and usefulness of the metric.

Cash Flow vs. EBITDA: The Basics

The net cash flow generated by a company’s operations after accounting for the necessary cash reinvestment, although more difficult to measure, is more directly related to ROI.

Net cash flow and EBITDA are non-GAAP measures often considered when pricing a transaction in the acquisition market. EBITDA is commonly used for ‘earn-out’ clauses in purchase agreements. For example, the pricing of a transaction might be 6.0x  EBITDA and an earn-out might be structured as an additional payout to the sellers if EBITDA exceeds a certain threshold during a specified subsequent period (e.g., an additional $500,000 paid to the sellers if EBITDA exceeds $10 million in a specified period subsequent to closing).

TSR is a more popular measure of company performance for executive compensation schemes among public companies because it reflects the cash return on investment to the shareholders over the specified period. EBITDA is the most popular measure of company performance for compensation to sellers for post-acquisition performance in private acquisitions because it reflects the profit generated by the company over the specified period. So, regarding cash flow vs. EBITDA, is one better than the other?

Investment Performance vs. Company Performance

If the ROI or TSR of an investment exceeds an appropriate comparative benchmark, does that mean management performed well? Does it mean that the value of the company has increased?

Maybe, and maybe not.

So, how does the performance of the company relate to the performance of your investment? To answer that question, let’s first clarify the difference between the investment and the company.

Investors provide capital, requiring a return on their investment. It may be interest on a loan or a claim on the residual cash flow after interest and principal is paid (i.e., equity).

The company’s invested capital (IC) includes capital raised from equity investors and borrowing. The value of the equity is the value of the IC minus the borrowed capital.  A bond, note, or bank loan is borrowed capital or funded debt. Liabilities such as trade accounts payable and accrued expenses are part of net working capital rather than borrowed capital.

As the business generates returns on invested capital (ROIC), they accrue to both lenders and shareholders. Lenders have a priority claim on the returns. The residual realized return greater than the principal and interest owed to lenders accrues to the equity shareholders. Generating realized returns greater than required returns is the essential principle of creating value. As the perceived risk of an investment increases, so does the required rate of return. Estimating the market’s required rate of return is a complex topic for another time. When the residual realized returns are greater than investor-required returns, the value of IC increases, and the residual shareholder value increases (assuming there is no change in the funded debt or perceived risk of the equity investment).

The proportion of borrowed capital to total capital is referred to as financial leverage. Borrowed capital carries a lower, contractually required priority return to the lenders, which means a lower investment risk.

The ROIC may differ from the ROI to shareholders, depending on whether financial leverage is employed. The ROI may also be different for different types of equity capital, which may be complex  (e.g., preferred stock versus common stock).

Thus, your investment’s performance depends on the company’s performance AND how your investment is structured.

EBITDA and Company Performance

When considering free cash flow vs. EBITDA, knowing if and where they are reported is useful. Earnings are reported on the income statement, while cash flow is reported on the aptly named statement of cash flow. However, the cash flow reported on the statement of cash flow is not necessarily sustainable net cash flow, and EBITDA is not often reported anywhere! EBITDA is an accrual-based measure that will only be reported voluntarily.

Accrual accounting matches cost with revenue regardless of when cash is received or paid. In contrast, cash flow is a measure of cash disbursements and receipts without concern for matching costs and revenue, the source of cash, or its recurring or non-recurring nature.

EBITDA is a measure intended to provide a sense of ongoing operating earnings. It excludes non-cash expenses (depreciation and amortization), income taxes and interest expense on debt. EBITDA is the most popular in the acquisition market. There, the acquirer can control discretionary decisions such as tax structure and financial leverage.

Cash flow is not an accrual-based measure and is subject to the timing variances of disbursements and receipts. Cash flow before payments of interest expense and principal is considered the unlevered cash flow.

Like EBITDA, the unlevered cash flow excludes the impacts of leverage but is different from EBITDA in that it is net of the payment of taxes and the replenishment of capital. Many investors focus on EBITDA in the acquisitions market. In this case, the investor is acquiring a controlling interest in the company and will control the degree of leverage.

EBITDA is also a popular metric for earnouts. These are mechanisms in purchase agreements that give sellers performance-based payouts. The deal often depends on EBITDA exceeding a given threshold. Using EBITDA reflects the company’s performance, excluding potential impact from the new owner’s decisions regarding the tax structure, financial leverage, and capital replacements. However, EBITDA only shows the company’s performance, not the investment’s.

Increasing the Value of the Company: Cash Flow vs. EBITDA

Should a company focus its efforts on increasing EBITDA or free cash flow? Which more closely tracks value?

To increase the value of the company, it is necessary to generate an ROI greater than the cost of capital. For each dollar of cash reinvested, the company must earn an ROI greater than its cost of capital to increase value.

There is no such benchmark of value creation for EBITDA. It can only be used to measure value if we assume a constant valuation multiple, potentially ignoring changes in the market.

Cash Flow vs. EBITDA: Which Is Better?

There are several measures of financial performance that are useful in understanding the ability of a company to generate value for its investors. EBITDA compares the performance of one company to another, but only sustainable cash flow relative to the amount invested is a true measure of financial performance. When paired with the correct benchmark (the risk-based cost of capital), it becomes clear whether the company is creating value or not.

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1. Planning and Staging a Company for Transition
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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Understanding Risk Management Basics for Business Owners
2. Selecting the Right Valuation Expert
3. What’s it Worth? Valuing a Business for Sale

This is an updated version of an article originally published on July 15, 2019 and updated on February 4, 2022.]

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