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Thomas Macpherson
Thomas Macpherson
Articles (144)  | Author's Website |

Why EBITDA Has No Role in Value Investing

A history of EBITDA and how it can be misleading

November 09, 2015 | About:

"I have made it a rule," said he, "whenever in my power, to avoid becoming the draughtsman of papers to be reviewed by a public body. I took my lesson from an incident which I will relate to you. When I was a journeyman printer, one of my companions, an apprentice hatter, having served out his time, was about to open shop for himself. His first concern was to have a handsome sign-board, with a proper inscription. He composed it in these words, 'John Thompson, Hatter, makes and sells hats for ready money,' with a figure of a hat subjoined; but he thought he would submit it to his friends for their amendments.

The first he showed it to thought the word 'Hatter' tautologous, because followed by the words 'makes hats,' which show he was a hatter. It was struck out. The next observed that the word 'makes' might as well be omitted, because his customers would not care who made the hats. If good and to their mind, they would buy, by whomsoever made. He struck it out. A third said he thought the words 'for ready money' were useless as it was not the custom of the place to sell on credit. Every one who purchased expected to pay. They were parted with, and the inscription now stood, 'John Thompson sells hats.' 'Sells hats,' says his next friend! Why nobody will expect you to give them away, what then is the use of that word? It was stricken out, and 'hats' followed it, the rather as there was one painted on the board. So the inscription was reduced ultimately to 'John Thompson' with the figure of a hat subjoined."

- Benjamin Franklin to Thomas Jefferson on editing the Declaration of Independence

When Wall Streeters tout EBITDA as a valuation guide, button your wallet.

- Warren Buffett (Trades, Portfolio)

Many enthusiasts of Occam’s Razor [1] would tell you the simplest solution is most frequently the best solution. Franklin’s milliner was a victim of such thinking in his new business. At the Nintai Charitable Trust, we sometimes think solutions can be found simpler and more plausible after cutting through seemingly insignificant data or arguments. However, we’ve found there have been instances in the financial markets where Sir Occam’s approach – where less is more – is probably not the best approach and serves our investors poorly. An example of this is the use of EBITDA in calculating a corporation’s value and as a tool to assess an investment opportunity.

EBITDA: A (mercifully) brief history

The history of using EBITDA really caught the public attention during the wave of leveraged buyouts and M&A wave in the period from the mid-1980s to the height of the technology bubble in the late-1990s. EBIDTA stands for Earnings Before Interest, Depreciation, and Amortization. The final “duh” (DA) of EBITDA are the platypi of corporate finance. Both depreciation and amortization are non-cash expenses, meaning no cash is exchanged. They are also expenses based solely on subjective estimates by managers and auditors. On the auditing continuum they can be judged by experience, industry standards all the way to other end of the spectrum to what we rank amateurs might call “fraudulent intent.” Since the 1980s, the use of EBITDA has become far more widespread with talking heads on CNBC announcing such-and-such a company is trading 12 times EBITDA. But what exactly does that tell us about the company’s value? Is it a tool value investors should have in their quiver?

EBITDA: Financial alchemy in the modern world

EBITDA has become such a normalized measure in today’s financial world, even companies without high asset and high capital needs are utilizing it on a regular basis for their earnings releases. A prime example of this has been Groupon (NASDAQ:GRPN) – the company that “drives more business though price and discovery.” In 2013 and 2014, the company showed losses of $95 million and $73 million by GAAP standards (see below). By announcing their numbers as EBITDA, the company miraculously turned these years into highly profitable periods earning $165 million and $130 million. We think the usage of EBITDA in these cases is particularly eggregious.[2] Beyond giving the company an entirely false financial façade, it calls in to question the judgment of both the company’s executives and board of directors.

Why this matters

For the Nintai Charitable Trust, EBITDA matters for several reasons. First, we enjoy valuing and investing in companies using a certain percentage of what we refer to as reality. For example, interest matters. Anybody who has seen what leverage can do (and debt is by its very definition leverage) knows that interest is a very real expense. Just ask any investor who saw their investments implode when what looked like free borrowing suddenly was cut off and their company was left in a situation not unlike a large bloated fish 50 feet from the water on an ebbing tide.

Equally important, EBIDTA can tell you a great deal about corporate management. Do these individuals really believe depreciation and interest can be taken “off-budget” as they say in Washington? Does a technology company really believe EBITDA is the best financial representation of their company? I would argue that anybody in the investment world – with the exception of the late Bruce “Bid ‘Em Up” Wasserstein – should and would look closely at any company making its business case with EBIDTA numbers.

Finally, I would argue that EBITDA has zero role in the calculation of value. We think Cody Boyte summed it up well when he said, “EBITDA does not take into account any capital expenditures, working capital requirements, current debt payments, taxes, or other fixed costs which analysts and buyers should not ignore. The cash needed to finance these obligations is a reality if the business wishes to grow, defend its position, and maintain its operating profitability (my emphasis)”. Perhaps Charlie Munger (Trades, Portfolio) put it most succinctly and pungently when he said, “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.

Conclusions

As value investors, we are dependent upon the accurate and timely reporting of financial returns by corporate management. A considerable aspect of this is reporting financial data that is consistent with GAAP standards and gives both investors and the markets a reasonable reflection of a corporation’s financial status. EBIDTA has become a Wall Street proxy for cash flow or as a replacement for GAAP earnings. In doing this, both management and analysts are doing a grave disservice to investors. Much as Franklin’s milliner, investors should be equally disgruntled and leery by management that disposes of numbers in a similar fashion from their financials.

The Nintai Charitable Trust has no positions (long or short) in the companies discussed in this article.


[1] Occam's razor (Latin: Lex Parsimoniae or 'law of parsimony') is a problem-solving principle devised by William of Ockham (c. 1287–1347), who was an English Franciscan friar and scholastic philosopher and theologian. The thesis posits that among competing hypotheses, the one with the fewest assumptions should be selected.

[2] As was GroupOn claiming marketing was a capital expense thus increasing their EBIDTA returns. This is an example of why Warren Buffett (Trades, Portfolio) said, “References to EBITDA make us shudder”. Other examples include Waste Management’s (NYSE:WM) indestructible garbage trucks and WorldCom’s capitalization of nearly everything that wasn’t bolted down (and more).

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (5 votes)

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Comments

Dr. Paul Price
Dr. Paul Price - 3 years ago    Report SPAM

It is often hard these days to find an unadulterated quarterly report that simply displays GAAP earnings.

You need to carefully read the footnotes to see what should be front and center.

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Thanks Paul for your comment. Your point is well taken. Sometimes even the SEC required translation between EBIDTA and GAAP can be incomprehensible. It takes a shrewd eye to make sense of financial statements these days. Thanks again for your comment. Best - Tom

snowballbuilder
Snowballbuilder - 3 years ago    Report SPAM

Hi tom interesting topic (as usual)

i will add my 2 cents on EBITDA

I think, if correctly used and in association with others, is a usefull metric.

When i study a company , EBITDA margin and EBITDA margin trend, and EBITDA-CAPEX are indicator i look (as well as EBIT margin and EBIT margin trend and others)

I think EBITDA has a rule both in economics (as an indicator of "gross operating margin") and both on financial (I Always check the annual FCF as Ebitda - taxes - delta NWC - ordinary capex (not m&a))

In my book when you study a company there are no "all season short cut" , you have first to understand the business and to study and understand the financial: all the financial (Profit&Loss , BS, Cash Flow) are important and correlated.

Profit and loss alone is inadeguate and incomplete,

you have to add and understand the balance sheet and the cash flow.

Then when you understand the company and the Sector you will usually progressively find a set of indicator that are the core KPI of the company (they are different for an insurance / a pharmaceutical / a retail - appareal companies) but again i think you have first to study the company and the financial 360%

And i repeat i think EBITDA if correctly used can have a role.

I agree Ebitda alone is useless but that, in my book, is true also for the GAAP net profit alone .

you have to understand the company and his financial .

there are no free lunch and any indicator alone is not "true or false" it depends how is used.

Just some thoughts best Snow

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Hi Snow. Thanks for your usual astute comment. I think there is a place for EBITDA....just not in value investing. Our disagreement might be at both a philosophical (as you call economic) as well as tactical (as you call financial) level. For the Nintai Charitable Trust, we simply don't see any value in removing the "ITDA" from our calculations. It tells us (again - a very personal judgement) nothing about the industry or economics of the business. On a financial level, we believe each of these expense categories are vital to understanding the nature, mechanics, and valuation of the firm. I know there are more similarities than differences in our view and I hope this doesnt come across as attacking your position. Thanks again for your usual thoughtful remark. Best. - Tom

The Science of Hitting
The Science of Hitting - 3 years ago    Report SPAM

I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.

Probably my favorite CM quote :) Thanks for the great article Tom!

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Thanks Science. Munger certainly has a way of putting it succintly yet with sublime eloquence. Best. - Tom

tripitaka
Tripitaka - 3 years ago    Report SPAM

No doubt EBITDA is a number that can be manipulated, just as "normalised" net profit can be. But I think it has a place in the valuation toolkit as long as you can calculate the true EBITDA figure rather than rely on what is presented to you: (1) like EBIT it allows you to consider business value before financial leverage; (2) amortisation charges usually do not align with economic reality & more often than not depreciation charges don't reflect the future capex profile either; and different companies adopt different approaches to D&A on equivalent assets; (3) it is most useful when making comparisons between companies in the same sector with similar asset profiles, thus avoiding the D&A accounting problem; (4) EBITDA less maintenance capex is probably the best use of the figure to get close to economic reality.

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Hi Tripitanka. Thanks so much for your comment. I think these are good points - but still don't convince me there is a role fot EBITDA in value investing! I think point 3 is the closest though. Thank you for your comment. Best. - Tom

ejreilly
Ejreilly - 3 years ago    Report SPAM

Nice article Tom. I really like the quote by Munger. Though, I think EBITDA may be a useful metric in comparative analysis amongst similar companies (similar line of business, asset levels, and debt levels) to get a snapshot of the use of estimates management uses to report depreciation & amortization. If the Net Income/EBITDA ratios are not similar, this can suggest that one company may be using too conservative/aggressive estimates. So EBITDA may be a good indicator, not to measure performance, but to measure the quality of the financial reporting by companies.

- Eddie

Open Mind Learning
Open Mind Learning - 3 years ago    Report SPAM

Hi Tom, thanks for a great article.

You cannot eat EBIDTA!. You cannot eat net income either but at least it includes ALL costs, incurred in the current or prior or in some cases future periods.

It is so disppointing to see great companies such as TransDigm use not only EBITDA, but amended EBITDA and EBITDA as defined as opposed to net income or Operating Cash flow in thier investor persentations and in their conference calls. I think one can adjust any of the numbesr to explain anomolies peculiar to a period or to the business to better understand the busienss. But none of them should be used to value the Company. Typically, these shanigans are used by management to put the proverbial lipstick on the pig. The shares are way over valued by normal measures so they use EBIDTA and other different metrics, which sound prfessional but really a way to take away your focus on the intrinsic value of the compnay.

Of course, the management is very clever the GAAP numbers are inlcuded but way back in the Appendix that shows the reconciliation. How many people have the time or the interest in following up with all that detail. Reminds of the insurance contracts of the past...important to read the small print.

Thomas Macpherson
Thomas Macpherson premium member - 3 years ago

Hey Eddie and OpenMind. Thanks so much for your comments. Yours - and everyone else's - have started me thinking to review your comments and refresh my own preconceptions on the subject. Is there more to learn here? Is their value I am missing? Thanks again for making that process a requirement. It was much appreciated. Best. - Tom

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