Value investing practitioners and academics have long studied the enterprise multiple effect, including my own business partners, Jack and Wes. The literature reveals that Enterprise Multiples, defined as total enterprise value of the firm divided by EBITDA, generate the largest spread between Value and Growth firms. The debate among academics is whether the enterprise multiple effect is attributed to mispricing or to higher systematic risk. That there is any debate at all suggests that investment bankers do not spend their spare time publishing on the topic. If they did, it would be less of a mystery.
As every investment banker knows, it's all about EBITDA. No other number under the sun arguably gets more scrutiny. EBITDA is practically written in blood. You think I am kidding? What follows is the brief story of EBITDA, and the people behind it.
The Story of EBITDA
Some people can see numbers in weird and wonderful ways. I know this to be true, because I used to work with them. Over 12 long years I labored up the ranks of an investment bank, where I was a managing director. While I am battle-hardened, numerically speaking, the fact remains that when I look at financial statements, I see mostly just numbers. Patterns only emerge to me with careful review.
But not for some people. For them, numbers take on new dimensions: colors, shapes, smells, topography. When you put a financial statement in their hands, those people can even smell blood. I have seen them swoop down, diving into the canyons of margin, barrel rolling over annual growth rates and skimming expense line items at low altitude and high speed.
Within seconds of spotting a number that sticks out, that doesn’t belong, their demeanor clouds. Some start to sputter—either uncontrollably or for dramatic effect. Their killer instincts kick in. They come out of the sky unseen, always with the sun behind them. The target in their sites, they flip the safety and squeeze the trigger. Pass after pass, they relentlessly strafe the hapless figure into oblivion. They leave only blood stains.
Those people are the killers that guard the gates. They are the enforcers…the terminators…the Deal Cops. The blood they spill flows day after day, night after night, from the cramped offices and conference rooms of investment banks in a handful of cities around the world—mostly New York and London.
Who bleeds? The bright, hard-working young men and women who prepare the numbers. Why do they bleed? Because they need to get the EBITDA right. To do so, they willingly labor away their lives in the trenches—the hours and days gradually wearing away the months and grinding down the years. Their blood, sacrificed at the altar of capitalism, is a raw ingredient of EBITDA. It takes a lot of blood to forge a number into EBITDA, and investment banks are the crucible. Most scandals are surmountable, but getting EBITDA wrong will wither an Investment bank.
Oh, you thought that businesses made EBITDA? Wrong.
Controllers and accountants pronounce EBITDA? Wrong again. It is not even a line item recognized by GAAP.
Investment Bankers Make EBITDA
Contrary to whatever you thought before, know you now this: Investment banks are where EBITDA is made. This is where the primordial dust of a Company comes together, for its big bang. A Company is not even relevant until it has EBITDA. Everything on it depends: Debt, equities, mergers, savings, pensions, skyscrapers, cities, resources, nations, wars. EBITDA is the fulcrum, the sine qua non. EBITDA is what pays for it all. It is pure and perfect, and it must be correct.
Like sausage, EBITDA is made in a grinder. It begins when a handful of ninjas, called a Deal Team, puts together a financial model for a company. From the far corners of the world, a company draws material inputs and talent, turning them into products or services. The deal team brings those numbers together in a financial model and begins to drape them in the Narrative. EBITDA always has a Narrative. Narratives are pitched, like horse shoes.
The Narrative is often the brainchild of a senior ninja on the investment banking Deal Team. To win the mandate, the Narrative must resonate with the Company's CEO. When the financial model is finished, the deal team drafts the Narrative into a Memo.
Enter the financial hit men, for the Memo is always unworthy. Why? Because the Narrative always has holes. There is a number that doesn’t belong. The Deal Cop caught a whiff before even reading the Memo. It is that number which kept the Deal Team’s analyst, associate and vice president at their computers for the last three days – and it stinks. It wreaks. The deal team knows this. They always knew it. It does not belong. Without a proper number, there cannot be EBITDA at the Company. Without EBITDA, there is no Narrative. How can you have any pudding, if you can’t eat your meat? It is that simple. And so there is blood.
The deal team goes back to the drawing board. Conference calls with the company’s management ensue. More all-nighters are pulled, lifespans shortened. Product pricing is suspect. Margin is unsustainable. Volumes might slip. The EBITDA must be supported. Narratives can only be built on a foundation of EBITDA. Only supportable Narratives become Road Shows and Deals.
And so it goes for a time, until the numbers are fixed and the EBITDA is ready. From a river, to a stream, to a trickle, the red ink gradually fades. The Memo passes through its final drafts. After four months of blood, the Deal Team is ready to place the Memo before the investment bank’s Committee for approval.
Earning the Committee's approval means the deal can go forward at the investment bank. Bonuses might get paid. Apartments might get bought or student loans extinguished. Committee is where getting can lead to having. However, the Committee is a killing field, and its chairman is the Dark Lord.
The Committee is not pleased with the Memo. Fingers point at the number that didn’t belong. After some sputtering and stammering, the blood flows. The Dark Lord requires more effort from the Deal Team. The EBITDA requires mitigating explanation, casting into doubt the Narrative. The senior ninja’s new apartment hangs in the balance. More blood will be required before all the numbers in the memo belong. The EBITDA must go unquestioned, and the Narrative must be embraced. And so it goes for this Deal and for every other Deal.
In the end, EBITDA comes off the line beautiful and pure, emerging into a world of shi#$, piss and corruption. From birth, men with hammers beat it, torture it, mangle it into lesser numbers, like net income, book value and EPS. These are not EBITDA, for they can be desecrated. The buck stops at EBITDA. Get it wrong, and there will be cataclysm. Global debt, totaling more than $230 trillion 1 must be priced, serviced and repaid, every second of every day.
Here, written in blood, lies the potential source of the so-called enterprise multiple effect.
- As of the third quarter of 2017, according to the Institute of International Finance ↩