The problem lies in what EBITDA leaves out. Chief among its omissions is capital expenditure (CapEx), the cash a business must spend to sustain its operations. While depreciation is accounted for as a non-cash expense that EBITDA rightly excludes, CapEx is very much cash out the door and ignoring it can result in significant overvaluation.

Let’s explore why Free Cash Flow (FCF)—which includes the impact of CapEx—maybe a more reliable indicator of value, particularly for capital-intensive businesses.

The Illusion of EBITDA: What It Ignores

EBITDA provides a “clean” view of operating performance by excluding:

• Interest: Financing decisions that are capital-structure specific.
• Taxes: Buyer-dependent and often optimized post-acquisition.
• Depreciation and Amortization: Non-cash expenses that do not affect today’s cash flow.

This treatment of depreciation has led to its common perception as “non-cash,” but that can be misleading. When a business purchases capital equipment, cash is typically spent all at once. For financial statement purposes, the cost is recognized over time through depreciation, which spreads the expense across the asset’s useful life. EBITDA removes this expense, but for buyers, the cash reality should not be ignored.

The CapEx Disconnect

Here’s where EBITDA may fail:

1. Depreciation vs. Real CapEx: Depreciation spreads costs over an asset’s life, but actual CapEx doesn’t always align with depreciation schedules. EBITDA ignores these timing mismatches, which can present an inflated view of cash flow.
2. Deferred CapEx: In capital-intensive businesses, equipment wears out and must be replaced. This is a future cash outflow for the buyer. A common seller practice is to defer CapEx a year or more before a contemplated sale to boost EBITDA. Buyers must identify this during due diligence by analyzing asset age, maintenance records, and replacement schedules. Deferred CapEx can result in a looming significant “catch-up expenses after acquisition.
3. Maintenance vs. Growth CapEx: CapEx can be divided into two critical categories: Maintenance CapEx: Required to sustain current operations and EBITDA. Growth CapEx: Investments made to expand capacity and grow earnings.

Buyers should carefully distinguish between the two. While Growth CapEx may represent upside potential, Maintenance CapEx reflects the true cost of sustaining cash flow and should be factored into valuation.

The Role of Industry in CapEx Dynamics

The relevance of CapEx—and therefore Free Cash Flow—varies greatly by industry:

• Capital-Intensive Industries: Manufacturing, infrastructure, and logistics businesses often require heavy ongoing CapEx to replace aging equipment and sustain operations. For these businesses, EBITDA fails to tell the full story.
• Asset-Light Industries: Software or professional services businesses typically have minimal CapEx needs, making EBITDA a more reliable cash flow proxy.
• R&D-Intensive Industries:  Companies in sectors like pharmaceuticals, biotechnology, and technology often face significant ongoing investments in research and development (R&D), which can also be a major cash drain, like CapEx.  EBITDA will overlook the long-term cash outflows required for innovation and product development to the extent that these R&D expenditures are required to be capitalized.  Capitalized R&D expenditures create intangible assets that are amortized (as opposed to depreciated) over their useful life.

Buyers must understand the industry norms for CapEx to avoid misapplying valuation metrics. What works for SaaS businesses does not work for manufacturing firms.

Why Free Cash Flow Maybe Superior

Free Cash Flow (FCF)addresses these issues head-on by incorporating CapEx into the equation:

FCF=EBITDA−Maintenance CapEx−Taxes±Changes in Working Capital

This adjustment matters because CapEx is not discretionary in capital-intensive industries.   Subtracting it reveals the true cash generation capacity of the company after sustaining its operations.

Implications for Valuation and Deal Structuring

To avoid overvaluation, buyers should consider:

1. Normalizing EBITDA: Subtract recurring Maintenance CapEx to reflect the cost of sustaining the business.
2. Performing CapEx Diligence: Identify deferred CapEx and future replacement needs through asset analysis.
3. Using FCF-Based Multiples: Enterprise Value (EV) divided by Free Cash Flow may offer a truer view of value.
4. Adjusting Purchase Price: For businesses with deferred CapEx, buyers may adjust the purchase price or structure holdbacks to account for upcoming investments.

For capital-intensive businesses, these adjustments may ensure valuations align with economic reality.

Tying FCF to Post-Acquisition Returns

The significance of Free Cash Flow extends beyond valuation—it underpins the buyer’s post-acquisition success:

• Debt Service: FCF determines the ability to service acquisition financing.
• Investor Returns: True FCF availability funds dividends, buybacks, or reinvestment.
• IRR Projections: Overestimating EBITDA while underestimating CapEx can derail internal rate of return (IRR) projections, undermining the financial logic of the deal.

For buyers, Free Cash Flow is not just a measure of current cash generation—it’s a cornerstone of future returns.

The Buyer’s Perspective: Short-Term vs. Long-Term

EBITDA has its place for buyers pursuing short-term strategies like “fix and flip” deals. In these cases, capital replacement risk may not materialize before the business is resold. But for buyers considering a long-term hold, Free Cash Flow maybe the superior metric because it:

• Accounts for the real cash cost of CapEx.
• Provides a more accurate view of sustainable cash generation.
• Highlights businesses with excessive CapEx requirements that EBITDA obscures.

Conclusion: Economic Reality Matters

EBITDA remains popular in M&A for its simplicity and comparability. But its convenience may come at a cost—particularly for capital-intensive businesses. Buyers relying solely on EBITDA risk overpaying for companies that consume significant cash to sustain their operations.

While EBITDA excludes non-cash items like depreciation and amortization, it also overlooks the ongoing cash needs for replacing assets or funding research and development.

Free Cash Flow, by factoring in both CapEx and capitalized R&D, provides an accurate measure of the true cash-generating capacity of a business. For buyers with long-term investment horizons, FCF may not be just a better metric—it’s the only one that truly reflects the economic reality of a company’s ability to generate sustainable cash flow. Whether evaluating hard asset replacement costs or the long-term financial commitments of R&D, FCF ensures that buyers make informed decisions that align with their post-acquisition success.

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