“Every time you see ‘EBITDA’, substitute it with ‘bullshit earnings’.” Such were the words of Charlie Munger at the 2003 Berkshire Hathaway annual shareholder meeting.
EBITDA is one of those smart sounding abbreviations frequently uttered by financial consultants — almost invariably to present themselves as erudite. Echoing the sentiment of Munger, however, the use of this metric may in fact reveal one’s ignorance rather than intelligence. There are a few important reasons why EBITDA can be a misleading metric with regards to depicting a firm’s financial performance. But in looking at its historical application, there may also be merits to this metric.
Depreciation is Not an Abstract/Mystical Expense
The primary reason why EBITDA misleads evaluators of financial performance is by its mistreatment of depreciation as an expense (or rather, a non-expense). It somehow treats depreciation as a form of nebulous, abstract, “non-real” expense that should not be accounted for in one’s analysis. And it justifies this merely by the fact that it is not a cash expense at the particular time period of analysis.
In Berkshire’s 2009 annual letter to its shareholders, Warren Buffet discusses the concept of “float”. Float — he said — has been the engine of Berkshire’s growth at the time, and it comes from the highly appealing business model of the insurance industry. Float means “get money now, pay expenses later”. The business model of the insurance industry necessitates for customers to pay premiums upfront, whilst expenses (in the form of insurance claims) are paid later — i.e. the insurance company is always paid in advance in the form of premiums, before any claims are paid out. In the meantime, premiums act as free money that will be used to pay general business expenses (utilities, wages, etc.), and will be invested on the short to medium financial market in order to generate returns. Thus, not only is the insurance company getting the payment upfront (in the form of premiums), they are also getting paid to hold the money (in the form of investment returns) before it is utilized to pay insurance claims.
Depreciation — Buffet argues — occurs because of a ‘reverse float’. Instead of receiving money upfront and paying expenses later, the company loses money upfront (by purchasing an asset) before receiving any revenue. The business is therefore risking capital (in a lot of cases, large sums of capital) before receiving any revenue. To treat depreciation as a non-expense would be to deny the economic reality of the situation. According to Buffet, depreciation is not only an expense, but the worst type of expense — as it necessitates the business to pay money upfront before receiving any revenue.
One can imagine a hypothetical example to illustrate the insanity of dismissing the realities of depreciation as an expense. Imagine a world where employee wages must be paid on a one-time basis upfront — a balloon payment upfront which represents the present value of their total future wages at the company for the next 30 years. Let us say that that number is $1,000,000. That is $1,000,000 of foregone cash today that must be paid to the employee in order for him/her to start working at your business.
Now imagine that for the next 30 years — a financial consultant informs you that wage expenses of $33,333 per year need not be included as an expense because it is a “non-cash expense” at every single year for the next 30 years that the employee will be working at your company. As Warren Buffet says: “Depreciation is not a non-cash expense — it is a cash expense — you just pay all the money upfront.”
Again, depreciation is the worst kind of expense, as it necessitates the business to pay all the money upfront instead of pro-rating payments yearly. Just like you would want to acknowledge the economic reality of the $1,000,000 upfront payment that you have made to your employee, you should also acknowledge the economic reality of any other asset in which you are forced to pay all the money upfront in order to retrieve that asset. It is therefore necessary — crucial — to acknowledge depreciation expense on a yearly basis. It is unwise — and borderline fraudulent— to completely disregard the existence of depreciation expense simply due to the non-existence of cash outflow in a particular time period. The cash outflow existed, and it existed at the worst possible time — all at the beginning. Thus, one must account for that for the remainder of the asset’s useful life.
Interest and Tax Expenses are Real — Just ask your Bank and your Government
The second reason why EBITDA misleads investors are through its disregard for interest and tax expenses. One of the other names often used interchangeably with EBITDA is “operating income”. This name supposes (for a possible nefarious reason that will be discussed later on) that interest and tax expenses are not part of the operating expenses of a business — thus, it should not be accounted for in one’s analysis of the business’ financial performance.
The definition of the “operating expenses” of a business should simply be this — any expenses that contribute to the existence and operations of the business. One does not need to imagine for long what would happen to the operations and existence of a business if management decides to halt outstanding interest payments to lending banks and tax payments to the government. Both the operations and the existence of the business itself would be in jeopardy. It is therefore ironic that interest payments to banks and tax payments to the government are considered trivial and unnecessary for analysis. Given that these two institutions most probably have the greatest power to disrupt the operations and the existence of the business more than any other institutions— payments made to them must be accounted for as part of the operating expenses of the business. They are arguably, the most important operating expenses.
The Perverse Incentives behind EBITDA
I mentioned a possible nefarious reason why interest and tax expense (as well as depreciation) are unaccounted for in the EBITDA analysis. This accusation originally comes from Buffet, and at face value, it does make sense. Buffet points the finger at the Wall Street consultancy institutions— who seem to have a strong incentive to provide artificially high valuations for their clients. High valuations lead to greater funding activities, either in the form of debt or equity.
Investment banks (mostly assisting in equity funding) as well as traditional banks (assisting in debt funding) benefit from higher valuations as it leads to greater commissions and interest payments to them. And the most surefire way to artificially increase a company’s perceived value is through the alteration of its net profits upwards, and upwards, and upwards — by negating more and more expenses.
The History of EBITDA
Perhaps we can better understand the reasons for the popularity of EBITDA by looking at its history. Some sources have cited billionaire telecom investor John Malone as the first applicator and popularizer of the EBITDA metric in the 1970s. In the highly capital-intensive business of telecommunications, Malone wanted to focus more on cashflow as a more accurate metric of financial performance. For his lenders and investors, it is cashflow that he believes best represents a firm’s performance (which is very true, the value of a firm is indeed the present value of its future cashflows). Thus, EBITDA was originally a proxy for the net cashflow of his telecom enterprises.
But what about the exclusion of interest and tax expenses? If EBITDA is a proxy for net cashflow, it is understandable that depreciation expense is excluded from the equation (given that it is not a cash expense for that particular year). But why also exclude interest and tax expenses (which are cashflow expenses after all).
There is also the need to gauge a company’s ability to service debt payments — especially in highly capital-intensive businesses such as telecommunications. Interest payments and tax payments tends to be the most predictably infrequent payments for a business —and it is usually paid at the end of a period, after more frequent payments such as wages, utilities, and rent have been paid. By analyzing the cashflow of the company before interest and tax expenses — but after the predictably frequent expenses have been paid — lenders are able to more accurately assess the firm’s ability to service their debt payments.
This is why EBIT (earnings before interest and tax) is appropriately used in the interest coverage ratio. It allows lenders to accurately assess the company’s capacity to cover its interest payments — after they have paid their daily operating expenses.
Another frequent reasoning for the exclusion of interest and tax expense in EBITDA is for standardization purposes. It is argued that — since interest payments depend on the company’s particular choice of capital structure (how much debt they wish to take on), when comparing the performance of a company with another company, we should remove their individual capital structure biases in order to make an apples-to-apples comparison. In other words — capital structure varies greatly from company to company, and this individual personal preference should not skew the comparison of financial performance between one company to another.
The same goes for taxes. If two companies operate in different jurisdictions — they will naturally be faced with different tax codes and thus tax expenses. It is therefore wise — for standardization purposes — to exclude tax expenses from one’s analysis in order to provide an apples-to-apples comparison.
The argument from both sides of the fence have their own merits. The Buffet-Munger duo certainly offers a compelling point of view. The denial of depreciation as a relevant expense in any given year is simply a lack of understanding on the true nature of expenses. And the denial of interest and taxes as a relevant expense is undermining the importance of lending institutions and governmental institutions towards the going concerns of the business.
However, as in the case with John Malone’s use of EBITDA, there is also value in understanding the net cashflows of a company within a given period of time. By simply adding back depreciation, amortization, interest and taxes back into net income, one can get a proxy for the amount of net cashflow the company has generated within a period of time. The problem is, there are more accurate ways of assessing the net cashflows generated from a business — and that is by looking at the company’s Statement of Cashflows, which depicts changes in cashflows from operations, cashflows from investing, and cashflows from financing activities.
If one wishes to analyze the cashflow dynamics of a company, using EBITDA is simply a lazy way of doing it — a heuristic (mental shortcut) that may seem simple and elegant, but may ultimately be misleading in many conditions. In the final analysis, perhaps the prevalent usage of EBITDA may simply come down to its perceived elegance and simplicity. One must always remember, however, that elegance and simplicity alone is not indicative of quality and accuracy.