Here is something that caught our eye this week:
the limitations of metrics
In the 1996 movie Phenomenon, John Travolta plays George Malley, a small town guy who is inexplicably transformed into a genius with telekinetic powers. In one part of the movie, he is asked to answer, as quickly as he can, how old is a person born in 1928. Malley answers as follows:
George Malley: Man or a woman?
Dr. Bob Niedorf: Why?
George Malley: Specifics, Bob.
Dr. Bob Niedorf: Okay, one more time. How old is a MAN born in 1928?
George Malley: Still alive?
Dr. Bob Niedorf: If a man is born in 1928, and he’s still alive, how old is he?
George Malley: What month?
Dr. Bob Niedorf: If a man was born October 3rd, 1928, and he’s still alive, how old is he?
George Malley: What time?
Dr. Bob Niedorf: 10 o’clock… PM!
George Malley: Where?
Dr. Bob Niedorf: Anywhere!
George Malley: Well, let’s get specific, Bob! I mean, if the guy’s still alive, born in California, October 3rd, 1928, 10 PM, he’s 67 years, 9 months, 22 days, 14 hours, and…[takes Bob’s hand to see his wristwatch]… and 12 minutes. If he was born in New York, he’s 3 hours older, now isn’t he?
One of Chenmark’s core values is to Keep Score. It follows, therefore, that we also like to track data points that provide insight into our performance. While the cardinal Chenmark metric is Free Cash Flow, we frequently refer to various other data points to gauge outcomes.
For instance, on the operating side, we talk a lot about gross profit, overhead burden, and unit economics. On the debt financing side, we key in on leverage and debt service coverage ratios. In marketing, we evaluate ROAS (return on as spend) and ROMI (return on marketing investment).
On the deal side, there is near-ubiquity in referencing EBITDA multiples when talking about the purchase price of a company. For example, if a company has $1,000,000 of EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization), and the purchase price is $4,000,000, it has a 4x multiple of EBITDA. While we confess to using this shortcut with regularity (peer pressure is a powerful force!), we more closely align with Berkshire Hathaway’s view of EBITDA as, well, bullsh*t.
For the sake of simplicity, we will bypass the discussion surrounding how to actually calculate EBITDA and over what timeframe (add-backs, adjustments, and pro forma projections are all tangents for another post), to instead highlight how Free Cash Flow and EBITDA can divert rather significantly. Take, for example, Company A, which produces $1,000,000 of EBITDA, and can be purchased for $4,000,000 purchase (4x EBITDA) versus Company B, which also has $1,000,000 of EBITDA, but will cost you $5,000,000 to acquire. Company A looks considerably “cheaper” than Company B ($1 million dollars!), but what about capital intensity? Let’s also say Company A has ongoing maintenance capital expenditure (“Capex”) needs of $300,000 while Company B only has Capex requirements of $50,000:
Now, Company B looks “cheaper” than Company A despite the higher purchase price as it is much better at converting EBITDA dollars to actual cash dollars (those are the ones you can spend). Of course, this is just the beginning of the discussion. Perhaps Company A structurally overspends on Capex or Company B chronically under invests in Capex, not to mention the importance of working capital and operating leverage. The point is, if we are only looking at EBITDA, we are missing important parts of the conversation and risk not seeing the full picture.
For Chenmark, this illustrates that the various metrics we frequently use are just the starting point for substantive discussion. A high overhead burden number might mean a lack of attention to salaried wage inflation, or it may be a reflection of deliberate growth investments. Declining debt service metrics may mean we’re heading for serious trouble, or that we just completed an acquisition. A low EBITDA multiple may be a marker of savvy investment, or it may be a sign of intellectual laziness. A person born in 1928 could be 67 years, 9 months, 22 days, 14 hours, and 12 minutes old…or he could be dead. We like to remind ourselves that in the world of small business operations and acquisitions, it’s never just about the metrics—it’s all about the specifics, Bob.
Have a great week,
Your Chenmark Team