Last week, I wrote about Warren Buffett’s 2013 letter to the Berkshire Hathaway shareholders. And I was particularly entertained by the following:
“Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.”
Part of the reason that this was so entertaining: a few weeks ago, I got complained at about the format of an Income Statement. Because where was the EBITDA number. Because that’s the only thing in the financial statements that’s useful.
EBITDA is “Earnings Before Interest, Tax, Depreciation and Amortisation”. It is not considered a reportable number by the standard setters at the International Accounting Standards Board (the IASB). You can obviously include it if you wish – in a summary, or in the directors report, or in an addendum. But it’s not required, and you have to be quite specific about that fact if you do decide to include it.
The main questions then: what exactly is EBITDA, why do people like it, and how is it so flawed?
What Is EBITDA?
Financial statements are more than just a regulatory requirement: financial statements are a story. It’s the reason you “read” financials – they’re a key-point summary of what happened in the last 12 months. Auditors come in at the end of the year to make sure that the story is both factual and grammatically accurate. And IFRS is the set of grammar rules.
Like any story, there is a main message to take home. For many people, it’s the “Net Profit After Tax” figure at the bottom of the Profit and Loss Statement. But often, you find analysts that prefer to use EBITDA, because the profit figure is a bit too broad-based for their liking.
So to be clear, the “Net Profit After Tax” figure is what the company has left to give to their owners after they’ve settled all of their obligations. Which makes it an amalgamation of a company’s activities:
- Its Operations – that is, how the company used its assets to generate income; which includes:
- Its Capital Investment Decisions – being the big assets the company chose to buy (land, buildings, machinery, etc); and
- Its Working Capital Decisions – which shows how management managed to turn its purchases into sales.
- How the company financed its big assets – specifically, how much it paid its lenders for the use of their money; and
- The company’s tax structuring.
Those activities are roughly represented by the following figures:
- Capital Investment Decisions, by Depreciation and Amortisation.
- Financing Decisions, by Interest Expense.
- Tax Structuring, by Taxation Expense.
- Working Capital Decisions, by whatever the profit figure was before 1, 2 and 3 were taken into account. Or, more simply: the EBITDA.
So when analysts look at EBITDA, what they’re saying is that it’s entirely irrelevant how a company structures its tax affairs, or finances itself, or how and when it chooses to buy its machinery. The only important thing is how quickly they can spin stock into turnover.
Why Do People Like It?
The general idea is that EBITDA is a leveller:
- Some companies have more debt than others, so they pay more in interest – but that debt is short term and will eventually be repaid; therefore, you shouldn’t count it.
- Depreciation and amortisation are “accounting expenses” that “don’t reflect how long you will use an asset for”, so you should just disregard them. Especially as they can fluctuate depending on when you last replaced machinery. And (this is always mentioned) you have completely abstract amortisation like that of goodwill.
- Taxation is not within the control of management, and should therefore be ignored.
So what we’re really talking about is people trying to get a good measure of long term performance. And so they try and exclude from that measure anything that is considered a once-off or temporary.
The Obvious Flaws
Here’s a list:
- Depreciation is not arbitrary. There is a cost attached to your large assets, you won’t be able to operate without them, and at some point, you’ll need to replace them. A company that replaces its equipment infrequently versus a company that is forced to replace its equipment constantly are going to have very different depreciation figures – which is reflective of how well, or how badly, they are treating their equipment. And that is going to have a long-term impact on future performance.
- Debt financing could be forever. How can you disregard a company’s debt burden?
- Taxation is controllable. Companies that overpay in tax are not spending enough time in tax planning. Companies that underpay in tax are probably spending too much time in tax planning. And taxation is a fact.
But more importantly, EBITDA is a distortion. It tries to create a simple measure for the complex combination of people and transactions that comprise the company in question.
It’s like saying that a white cell count is all you need to tell if a person is unwell.
But what if they have a broken arm?
The point is: no metric is useful in isolation.