While some companies are valued based on multiples of earnings or sales, many of today’s public companies seem to be valued on EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization. Cannabis companies are especially often judged on EBITDA, so it helps to understand EBITDA’s origin and limitations.

Bond markets have always been bigger than stock markets (at least partially due to the huge amounts of bonds issued by the U.S., state, and local governments). Larger institutions are big players in bonds but are generally limited to bonds that are “investment grade,” (i.e. above a certain minimum rating issued by one of the major bond rating agencies like S&P, Moody’s, etc.). The action at the top of bond ratings leaves most smaller investors out and is generally very stable and boring. The more exciting areas of bond markets are in the “junk bonds,” (i.e. below investment grade rating or no rating bonds).

In the 1980s, junk bonds became very popular, and the more popular they became, the more companies sought to use junk bonds as an attractive form of financing. Selling stock is usually selling upside and inviting investors to think of what heights the stock can attain if the company performs well. Selling bonds involves selling downside protection - when highly-rated, safe bonds are paying investors 3% interest, selling a junk bond means convincing the investor they can take just a tad bit more risk but get a 7% return, for instance, instead. The more comfort you can give the bondholder that you are a creditworthy company, the cheaper your capital becomes.

Accounting is the language of business, but it’s a bit stilted and inflexible. So, companies often come up with alternative measures to try to convey how well a business is performing. These measures can range from very helpful in providing a look into the “true” performance of a business (e.g., “Daily Active Users” for many software platforms, “Gross Merchandise Volume” for sales platforms like Amazon and Alibaba, etc.) to alternatively not being particularly helpful in helping investors determine a business’ future performance (e.g., “funded capacity” as used by the Canadian LP cannabis companies).

Enter EBITDA, first created and popularized by John Malone and his team. Still active in the business today, John Malone made his initial fortune in cable on the way to becoming the largest private landowner in the U.S. To aggressively sell well-priced junk bonds to finance the cable empire he was building, Malone needed a way of showing bond buyers that his companies were safer than they looked.

In those days, bondholders often looked at a company’s earnings to determine creditworthiness, but Malone argued something different: earnings are an accounting opinion, not a fact. The cable business, with huge non-cash depreciation from high capex builds and amortization from acquisitions, would generate accounting losses for years, all while still generating strong cash flow to cover interest expense.

For a bondholder in the 1980s, EBITDA was a rough approximation of cash flow - interest was deductible so bondholders stood in front of taxes, and depreciation and amortization were non-cash charges. John Malone pounded the pavement on Wall Street and successfully convinced many investors to adopt EBITDA as a measure of a company’s ability to generate cash flow.

As with many things, EBITDA has strayed a bit from its original purpose:

• EBITDA is often being used as a shorthand for “cash flow” even when talking about equity. But equity does not get paid interest that is tax-deductible, and, save the effect of credits and loss carryforwards, profitable businesses usually have to pay corporate taxes in cash before they give anything to equity holders.
• EBITDA always underestimated long term cash flow because almost any business needs to reinvest some portion of its cash for upkeep, so depreciation does become a cash expense of some magnitude.
• Cannabis facilities cost a lot upfront and some investors’ underlying assumption seems to be that they never require upkeep or significant future expenditures. While not on the level of the initial cost, cannabis facilities are like any other large facility and require at least some level of maintenance capex. Future price competition in many states will force upgrades to certain suboptimal facilities - upgrades that will be paid for in cash.
• Lately more public companies, and cannabis companies specifically, are reporting “Adjusted EBITDA,” with the “Adjustments” usually being one-time expenses and stock-based compensation. While not a cash expense, a high level of stock-based compensation can be dilutive, effectively entitling shareholders to less cash in the future and ultimately getting to largely the same place as a cash expense.

This isn’t to say that EBITDA is necessarily a bad measure - it’s valuable as far as it goes, but it just has limitations that need to be kept in mind. We look at EBITDA as one of a number of factors when we look at the cannabis landscape and encourage other investors to do the same.

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