The earnings before interest tax depreciation and amortization metric, or EBITDA, splits opinions. On one hand, there are those analysts and investors who hate using EBITDA because it provides a misrepresentation of the company's finances. On the contrary, for businesses with high capital spending requirements and interest costs, some analysts will claim this metric is a more appropriate representation of its growth. EBITDA has also been proven to be a strong determining factor of value when combined with enterprise value. The metric is commonly used to judge a company's level of gearing, giving a simple and easy to understand picture of leverage.
Two of the world's most prominent value investors, Seth Klarman (Trades, Portfolio) and Warren Buffett (Trades, Portfolio), both dislike this metric. Over the years, they have commented on several occasions why they prefer not to use EBITDA. In all cases, it comes back to the same argument: it is just not possible to trust the numbers.
It is easy to understand why they take this view. EBITDA was invented to be used as a way of convincing lenders a company could sustain its debt in the leveraged buyout boom of the late 1980s. As Klarman described in his book "Margin of Safety":
“In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number that would quantify a company‘s cash-generating ability. The cash-flow calculation the great majority of investors settled upon was EBITDA (earnings before interest, taxes, depreciation and amortization). Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant. Even non-leveraged firms came to be analyzed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate. Unfortunately, EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.”
One of the reasons EBITDA has gained a following is because many analysts believe it can be used as a proxy for corporate cash flow, a view Klarman also disagrees with:
"It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company‘s ongoing income stream. Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out. In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipated sharp reductions in capital expenditures. Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results."
EBITDA is designed to present the best possible view of a company. Unfortunately, in the real world, ignoring unavoidable costs of doing business such as depreciation, tax and interest charges will result in unreliable figures. As Klarman says:
"Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because all the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). One hundred percent of EBITDA would thus be free pre-tax cash flow available to service debt; no money would be required for reinvestment in the business. This view was flawed, of course. Leasehold improvements and parts of a machine are not typically financeable for any company. Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose. An overleveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.”
All in all, the figure is highly unreliable and is almost always used to justify premium valuations the company does not deserve. Klarman notes in his book:
"EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. This would be a clear case of circular reasoning. Without the high-priced takeovers, there were no upfront investment banking fees, no underwriting fees on new junk-bond issues and no management fees on junk-bond portfolios. This would not be the first time on Wall Street that the means were adapted to justify an end. If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.”Â
 Occasionally, EBITDA is even used to camouflage downright fraud. As Buffett notes:
“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 (WMT, Financial), GE (GE, Financial) and Microsoft (MSFT, Financial) — 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."
Disclosure: The author owns no stocks mentioned.
