Seth Klarman on Ebitda and Why Investors Shouldn't Use It

Thoughts from the guru about one of Wall Street's favorite metrics

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Apr 28, 2020
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Earnings before interest, tax, depreciation and amortization (or Ebitda) has become one of Wall Street's favorite metrics over the past few decades.

However, some of the best investors of all time believe it is a waste of time and effort trying to work with this metric.

Charlie Munger (Trades, Portfolio), the vice-chairman of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), has even gone so far as to say that Ebitda is "ridiculous," and he has accused managers who use Ebitda to evaluate company performance of "intellectual dishonesty."

Klarman on Ebitda

In his book "Margin of Safety," Seth Klarman (Trades, Portfolio) explains why Ebitda should never be relied upon to place a value on a business. The value investor said that Ebitda, which is frequently used as a proxy for free cash flow, is a "flawed" measure of cash generation because it "masks the relative importance" of several components of corporate cash flow.

In his book, he presented the example of two companies, Service Company X and Manufacturing Company Y. Both had revenues of $100 million for 1990. Company X reported cash expenses of $80 million with zero depreciation and amortization expenses, giving earnings before interest and tax (Ebit) of $20 million and Ebitda of $20 million. Manufacturing Company Y reported cash expenses of $80 million, depreciation and amortization expenses of $20 million, Ebit of $0 and Ebitda of $20 million.

Looking at these two companies, Klarman remarked, an investor looking at Ebitda would value both businesses equally. He went on to add, "At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing." While the two companies have identical Ebitda, "they are clearly not equally valuable."

Company Y, as a manufacturing business, must be prepared to reinvest its depreciation. This could eliminate free cash flow. In comparison, Company X has no capital spending requirements and thus "has substantial cumulative free cash flow over time."

"Anyone who purchased Company Y on a leveraged basis would be in trouble. To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when plant and equipment needed to be replaced. Company Y would eventually go bankrupt, unable both to service its debt and maintain its business. Company X, by contrast, might be an attractive buyout candidate. The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors."

While this statement is given from the perspective of a private equity buyer, it's no different for the average investor. If we assume that whenever we buy a stock, we're buying part of a whole business, we should be looking for companies that can return plenty of capital to investors.

If a company has to reinvest all of its capital back into operations to remain competitive, it is not going to be a good investment in the long run. If the business hit problems and has to borrow money, this could constrain its ability to reinvest going forward, which may mean that shareholders have to put in additional capital.


Ebitda may have some uses, but I agree with Klarman that it should not be relied on by itself to value businesses.

Stripping out a cost like depreciation ignores one of the most significant costs of doing business. This could lead to unexpected problems further down the line if you buy a company expecting free cash flow to match the Ebitda figure.

What's more, if management is targeting a certain level of cash flow as defined by Ebitda margins, it could lead to creative accounting or fraud. Investors may want to stay away from these types of businesses.

Disclosure: The author owns shares in Berkshire Hathaway.

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