“I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” – Charlie Munger (Trades, Portfolio)
Originally utilized as a way of incorporating goodwill amortization for companies which had substantial goodwill amortization charge due to acquisitions in which the purchase price vastly exceeded the book value of assets acquired, EBITDA has evolved into a mental shortcut popular among many investors, I-bankers, reporters, analysts and corporate management teams.
I have found it shockingly and uncomfortably inadequate that so many investors equate EBITDA with earnings or cash flows. I perfectly understand why crook management team and I-bankers trumpet the use of EBITDA, or better yet, adjusted EBITDA but any serious investor should understand the major shortcomings of EBITDA.
Let us first remind ourselves of what Mr. Buffett had warned us long time ago on EBITDA:
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
While there are many shortcomings of using EBITDA, the biggest problem I have with EBITDA is that most of the time, companies which use EBITDA are often businesses with significant and real ITDA expenses. I can write many more words on those shortcomings but what I really want to share with readers is a simple EBITDA checklist. I don’t use EBITDA personally but for those readers who rely on EV/EBITDA multiples, it may well be worth the time to go through the checklist, which only has a few items.
- What are the ratios of I/EBITDA and DA/EBITDA? What is the combined ratio of IDA/EBITDA. In other words, how much EBITDA is generated by excluding interest, depreciation or amortization?
- How much capex is needed in the business? Compare capex to depreciation.
- If amortization is a substantial charge, you should evaluate whether the amortization charge is economic charge or GAAP charge.
Let’s walk through an example. The following tables are from Pioneer Energy Services (PES, Financial) spresentation:
For a company with horrible economics, PES’s management team was able to turn losses into good-looking EBITDA numbers. Let’s walk through the checklist using 2013’s number.
- I/EBITDA = 48.4/234.7=20.45% DA/EBITDA=187.9/234.7=80%. IDA/EBITDA=100.45%
- Now let’s compare D&A to capex. The following table says it all.
| Â | 2009 | 2010 | 2011 | 2012 | 2013 |
| D&A | 106.2 | 120.8 | 132.8 | 164.7 | 187.9 |
| Capex | 115 | 131 | 210 | 364 | 165 |
| Capex/D&A | 1.08 | 1.08 | 1.59 | 2.21 | 0.88 |
3. Not applicable as most of D&A are depreciation expenses.
So here we have a company that derives 100% of management presented non-GAAP earnings by excluding real expenses and has to spend an capex amount at least as much as D&A expenses every year. Charlie Munger (Trades, Portfolio) would say that any idiot can tell that in this case the use of adjusted EBITDA is absolutely twaddling. If you are using adjusted EBITDA/interest expense to calculate interest coverage, or using EV/EBITDA to value PES, I think you need to have second thought.
Let me end with another Buffett quote on EBITDA:
"We’ll (Berkshire Hathaway [BRK.A][BRK.B]) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Walmart (WMT, Financial), General Electric (GE, Financial) or Microsoft (MSFT, Financial). The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them."
