Assess using EBITDA and net income as stand-ins for cash flow when valuing a firm

Net income is a poor stand-in for free cash flow to equity because it includes non-cash charges and gains, excludes investment in fixed and working capital, and ignores net borrowing. A company can report rising profits while consuming cash to fund expansion. EBITDA is a poor stand-in for free cash flow to the firm because it ignores taxes, which are a real cash cost, and ignores the capital spending and working capital needed to sustain the business. Capital-intensive companies look far healthier on EBITDA than on free cash flow. Net income approximates FCFE only when fixed-capital investment roughly equals depreciation, working capital is stable, there is no net borrowing and there are no other large non-cash items. EBITDA overstates FCFF even then, because taxes are a cash cost. The trap is valuing a growing, capital-hungry business on a multiple of EBITDA as if EBITDA were cash.