At the beginning of 2016, Bank of America Merrill Lynch published a report which highlighted how prevalent the use of earnings before interest, tax, depreciation and amortization was becoming among companies.
The findings were amazing. Between 2011 and year-end 2015, the percentage of companies reporting adjusted earnings increased sharply from around 75% to about 90%. Even though this report is two years out of date, I believe it is still highly relevant today.
With the S&P 500 trading at one of the most demanding multiples of all time, valuing businesses based on EBITDA, a very misleading metric, is bound to end badly.
Warren Buffett (Trades, Portfolio) is well aware of the pitfalls of EBITDA. Over the years, he has issued multiple warnings to Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) shareholders about this misleading metric, and why every investor should avoid it.
With this being the case, I thought it would be interesting to gather some quotes from Buffett on the drawbacks of EBITDA as a warning that this time, it is not different.
Buffett on EBITDA
First of all, capital spending is a cost of doing business, no matter what you might want to believe. In his 1989 letter to shareholders, Buffett wrote:
“Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures.
You might think that waving away a major expense such as depreciation in an attempt to make a terrible deal look like a good one hits the limits of Wall Street's ingenuity. If so, you haven't been paying attention during the past few years. Promoters needed to find a way to justify even pricier acquisitions. Otherwise, they risked - heaven forbid! - losing deals to other promoters with more 'imagination.'
So, stepping through the Looking Glass, promoters and their investment bankers proclaimed that EBDIT should now be measured against cash interest only, which meant that interest accruing on zero-coupon or PIK bonds could be ignored when the financial feasibility of a transaction was being assessed. This approach not only relegated depreciation expense to the let's-ignore-it corner, but gave similar treatment to what was usually a significant portion of interest expense. To their shame, many professional investment managers went along with this nonsense, though they usually were careful to do so only with clients' money, not their own. (Calling these managers 'professionals' is actually too kind; they should be designated 'promotees.')"
Second, in his 2001 letter, he said EBITDA presents a misleading picture of the underlying fundamentals:
"Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as 'EBITDA' and 'pro forma,' they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to 'restructure' my putting stroke and therefore only count the swings I take before reaching the green.)"
And third, in his 2002 letter, Buffett once again warns of the dangers of removing a cost from the company’s income statement that has a definite impact on the business, which should not be glossed over.
"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?"
Disclosure: The author owns no stocks mentioned.
