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Jacob Wolinsky
Jacob Wolinsky
Articles  | Author's Website |

EBITDA: Warren Buffett Versus Everyone Else

It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.

We won't buy into companies where someone's talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don't, I suspect you'll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft -- they'll never use EBITDA in their annual report.

People who use EBITDA are either trying to con you or they're conning themselves. Telecoms, for example, spend every dime that's coming in. Interest and taxes are real costs."

Source: Berkshire Hathaway Annual Meeting 2002 Tilson Notes

Time: 2002

The above quote shows that Warren Buffett is not found of using EBITDA as a valuation metric. Buffett has made similar remarks about EBITDA on other occasions mocking the use of EBITDA.

Many big Buffett fans and value investors use EBITDA. Some of the greatest investors use EBITDA including David Einhorn look at metrics like EBITDA. Companies, in their press releases many times like to highlight EBITDA. Sell-Side analysts almost always project EBITDA in their models, and discuss EBITDA in valuing a company.

Should you go with Warren Buffett or nearly everyone else in regards to EBITDA?

It is important to realize how great of an investor Buffett is before anyone can either take either side of the debate.

First, by taking a closer look at what EBITDA really is one be able to dissect both viewpoints a little bit more clearly. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a simple enough concept to understand, and is quite useful for investors when trying to measure a company’s actual cash flows (using the term loosely here) and other metrics before accounting for deductions. It gives a “behind the scenes” sort of look at a company, and can really help investors with understanding what a company’s capabilities and upside are.

A great example for why anyone would consider looking at EBITDA would fall along the lines of potential. A company might have been successful in terms of maximizing sales and minimizing costs, yet if they have just recently made high investments in assets, they have to properly depreciate those assets. It is a very good plan for investors to follow, because when the depreciation has been paid off (or whatever the numbers are that force the company to make the earnings appear smaller), then the company will appear to be in a much healthier and more profitable position. The truth is that they are still operating in the same way as before but now they are able to realize higher earnings.

Now, Warren Buffett is one of the simplest men possible while still remaining one of the smartest and most successful investing Gurus perhaps of all time. The reason he has been so successful could be attributed to pure intelligence, hard work, and more likely a combination of the two. Whatever the reasoning is, however, he definitely tries to keep things very simple without overanalyzing anything. In fact, one of his most popular quotes is, “Beware of geeks bearing formulas.” Those that have followed him truly understand that he wants to get a sense of the whole picture and make a judgment from that information.

Warren Buffett also understands that traders themselves are only looking to buy and sell, whereas his belief is that one should make investment decisions as if they were only going to buy half of a dozen stocks in their entire life. The amount of research would have to be first class and you couldn’t leave a single stone unturned. One also couldn’t afford to manipulate the stats in a way that would steer you one way or another in regards to whether the stock was a good buy or not.

Once one has a fairly clear understanding of Buffett, one can imagine what he is thinking when it comes to investing with measures like EBITDA. His argument also makes sense whether or not you actually agree with it. An investor cannot simply look at the numbers produced from EBITDA and use them as benchmarks for a few reasons. One, like he states in the quote listed previously, paying interest, taxes, and depreciation are part of the process of doing business. A company cannot gloat about EBITDA with the hopes of proving how successful their operations were. This is like a company reporting great top line numbers without discussing costs and the bottom line numbers. The fact is that as long as the items of EBITDA are used as part of the everyday operations and makeup of the business, then why would you report the numbers without listing them?

Another major reason to look at EBITDA with a skeptical eye is that investors are looking at a company without accounting for a major input. One could get much better numbers out of almost every company by simply eliminating one variable, but the fact is that you wouldn’t be getting truthful results by doing so. GAAP is far from perfect but that is beyond the scope of this article. When taking out certain variables an investor would be getting results that have a “would have been great, except …” mentality. Unfortunately, investors want stocks with results and not ones that have excuses.

Overall Buffett has a mentality of taking the whole picture in and making sure that he understands everything in order to make a sound judgment based upon all of the facts and figures. One does not have to agree with his methods, but they are as objective as ratios can be. Buffett doesn’t want to “cut out” the vital information, and for that reason alone he might owe a lot of his success as an investor.

Disclosure: No stake in Berkshire Hathaway, and not a fan of EBITDA

http://www.valuewalk.com/

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 3.5/5 (35 votes)

Comments

Alex Morris
Alex Morris - 6 years ago    Report SPAM
Great article Jacob, thanks for taking the time.
halis
Halis - 6 years ago    Report SPAM
You are exactly right, about Buffett and about why EBITDA is all but useless. It makes no sense to me either. Why would you want to look at a metric that tells you, "This is what we would have made if it weren't for all the interest, taxes, depreciation and amortization that we had to pay/account for."

In other words, "If we were in fantasy world, this is what our profit would have been." Go look at DirecTV and see how EBITDA correlates to their actual cash flow or earnings.
Mariusz Skonieczny
Mariusz Skonieczny - 6 years ago    Report SPAM
While EBITDA has limitations just like GAAP earnings, I would not say it is useless simply because everyone else is using it. When the time comes that you will be selling your stock, wouldn't it be useful to know what the buyer is going to look for? If the buyer is looking at EBITDA, I want to be aware of it.
halis
Halis - 6 years ago    Report SPAM
IMO you can't base your selling price on what some madman is willing to pay, who is looking at EBITDA....
dirt2624
Dirt2624 premium member - 6 years ago


The article could have been much better by comparing Buffett's 'owners earnings' to ebitda and using a few examples from different Buffett purchases in various industries.

Give us gaap earnings and let us, the analysts, develop benchmark adjustments from there. That is what gaap is there for.
cm1750
Cm1750 - 6 years ago    Report SPAM
I have never been a fan of EBITDA.

If you were to buy a dry cleaning business, would you use EBITDA to come to a purchase price? No.

When the price is 8x EBITDA, what is your annual return on the investment? No idea.

I love economic earnings (FCF less option expense) that are normalized for growth capex. If you tell me the P/eFCF is 12.5x and the FCF will grow 3% long-term, I know my approximate return - roughly 11% as I am getting an 8% FCF yield + 3% growth in business value every year.

Theoretically, EBITDA is useful for comparing the relative valuation of firms with different capital structures, but I don't use comparative analysis, I look at expected absolute IRR. I account for debt by mainly focusing on whether there is default risk in bear case scenarios.

IMHO, the only real use for EBITDA is for bank loans where banks require a certain coverage ratio - this is especially important for private equity firms that use it to determine their required equity contribution in a deal.
brianbook
Brianbook premium member - 6 years ago
For about 18 years, I have been a long, bottoms-up, value investor, i.e. a Berkowitz wanna-be. I have done much better during the Clinton & Obama administrations. During the Bush years, the DOW went from > 10,000 to 6,547. It was challenging for an investor like me to make money during the Bush administration (kudos to Berkowitz). I fully intend to learn the art of short-selling before the next Republican administration.
halis
Halis - 6 years ago    Report SPAM
Does Berkowitz actually short sell? I thought he was long only...
yswolinsky
Yswolinsky - 6 years ago    Report SPAM
Dirt

Thanks for the suggestion maybe I will write an article on the topic of owners earnings .

Brian

Good luck with your "bottom up" investment strategy :)
halis
Halis - 6 years ago    Report SPAM
Owner earnings is basically just free cash flow calculated rationally.
brianbook
Brianbook premium member - 6 years ago
Sorry, this comment was meant for another article. I apologize.
supratik
Supratik - 6 years ago    Report SPAM
EBITDA by itself is not useful at all but when using ratios I still find it of value. On it's own it can be misleading because it doesn't give a 'sense' of expenses to come in future periods. Hence the incentive for management to play around with it.

I have somewhere an interview of Jean-Marie Eveillard where he mentions that EV/EBITDA is something that First Eagle uses to value companies. So there are at least a few 'guru' investors out there who do use EBITDA in calculating ratios.

It is probably more useful to use EV/EBITDA when comparing companies across countries as there are differing tax structures and other depr./amort. regulations in play. When comparing companies in the same country one can probably use EV/EBIT as students at Columbia Univ are taught in their Value Investing class (as evidenced from valuation exercises in their newsletter) these days. I find EV/EBIT to be more conservative as a valuation tool so ceteris paribus, a stock with lower EV/EBIT should be a better and safer buy.

Again EV/EBITDA or EV/EBIT are just one tool among many to use for valuation. Or you can ignore it as well if you are Buffett.

The thing about Buffett is that he has an uncanny, maybe unique, sense of breaking down to a basic level how any business works and finding a simple way to value it as a cash producing machine. Which is why he can eschew a lot of fancy calculations (that probably amounting to nothing) that we are taught at b-school.
rob.will
Rob.will - 6 years ago    Report SPAM
Great article as always from an insightful investor. Thanks Jacob. Now I wonder, if a better metric to use wold be Buffett's "owner earnings". Any comments or insight would be greatly appreciated.
Alex Morris
Alex Morris - 6 years ago    Report SPAM
rob.will,

Owners earnings is a much better metric (IMO); it is similar to FCF, but with an adjustment made for maintenance CapEx. Essentially, these are the net cash flows to the business after accounting for investments needed to maintain the current level of unit volume and competitive advantages. Maintenance CapEx must be estimated, so it will not reveal precise figures like other metrics. However, there is a big difference between trying to figure out this value, rather than saying skip it. (this was highlighted in the 1986 shareholder letter)

Regardless of any metric used, the point still stands: you cannot pick a single ratio/measurement to determine the attractiveness of a securities valuation. You MUST understand the business, analyze the moat, etc. (all those things that Buffett/Munger/great value investors always talk about).
halis
Halis - 6 years ago    Report SPAM
Alex,

I believe you are correct and maintenance capex is Buffett's primary contribution to FCF calculation and what really distinguishes OE from FCF.

That's the hard part though as it's so subjective.
Alex Morris
Alex Morris - 6 years ago    Report SPAM
Halis,

This is true. Two possible solutions I can think of. First: look through recent 10-K's, and compare overall CapEx spend to growth strategies; especially with times like the recent recession, you may be able to pull out some color on what is being used for growth and what is maintenance. Second: contact management; they might not give you an exact figure, but can probably lead you in the right direction.

If both of these prove ineffective, my personal strategy would be the conservative route; use an average CapEx in its entirety as your measure for maintenance CapEx. Even though this will almost definitely overstate it, better than underestimating/skipping it all together (at least IMO).
mcwillia
Mcwillia - 6 years ago    Report SPAM
EBITDA is popular among those looking for relative value. None of us seem to be very interested in relative operational comparisons, and Buffett could care less about relative value. He's looking for the prettiest girl, not the prettiest girl in the bar.

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