Analyzing Companies Is A Complex Affair: Don't Use EBITDA

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 |  Includes: AAPL, XOM
by: Intangible Valuation

EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization.

It is used to measure "cash flow" and was first deployed as a "sawed off yardstick" -- to use Warren Buffett's words -- during the leveraged buyouts of the 1980s. Seth Klarman suggests that "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" [1]. As a rule, EBITDA overstates cash flow -- likely by a significant amount.

How EBITDA Fails

Despite its use during the leveraged buyouts of the 1980s, EBITDA is poor and incorrect as a guide in most cases. Take, for instance, an EBITDA comparison between Apple (NASDAQ:AAPL) and Exxon (NYSE:XOM):

AAPL EBITDA TTM Chart

AAPL EBITDA TTM data by YCharts

Exxon must be way more valuable, right? I mean, the cash coming in must be significantly higher than Apple, right? Lesson One: EBITDA ignores cash needed to fund working capital and other non-cash charges.

If we look at Exxon's and Apple's operating cash flows, defined as:

Operating Cash Flow = Earnings + All Non-Cash Expenses and Gains + Changes In Working Capital

We see that the companies are far closer in cash generating abilities than a EBITDA measure would propose:

AAPL Cash from Operations TTM Chart

AAPL Cash from Operations TTM data by YCharts

The cash from operations figure it is better than EBITDA at measuring cash flow because it takes into account (1) inventory level changes, (2) changes in accounts receivable and accounts payable, (3) impairments, (4) other working capital changes, (5) and all other non-cash charges. It is far more comprehensive -- and it is required by GAAP and the SEC, so there is no need to "calculate it." Just look it up.

Further, and as we all know, Apple has no debt -- therefore there is no interest expense (no "I" contribution in EBITDA). Lesson Two: EBITDA pretends interest payments, and therefore debt level and capital structure, do not effect cash flow.

All this is to say, therefore, that on a "cash coming in" basis, Exxon is not 72% greater than Apple as EBITDA would suggest, but only 6% greater. There is, however, one last point which is the most important of all.

Depreciation and Capital Expenditure

When we calculate EBITDA, we add back depreciation because it is a non-cash charge in the period. But it was a cash charge when the depreciable property was obtained. And considering that we value most businesses as a "going concern," it seems pretty reasonable to think that the business will want to replace its property once it wears out. This replacement cost is generally tucked into the line item called "capital expenditures."

Lesson Three: EBITDA ignores the fact that depreciation is offset by capital expenditure.

EBITDA does not take into account that more property will need to be purchased -- at some point -- to replace the depreciation of property in use today (or "depleted," as in the case of Exxon's oil and gas properties). EBITDA doesn't address one of the most fundamental aspects about business: the need and requirement to purchase property and revenue generating assets.

Let us look at Exxon's and Apple's capital expenditures:

AAPL Capital Expenditures Chart

AAPL Capital Expenditures data by YCharts

Exxon clearly needs a significantly greater amount of property than Apple. EBITDA completely misses this point. The fact that Exxon spends more money on property overtime allows its depreciation charge to grow large enough to make the depreciation charge single handedly increase EBIDTA to such an extent that Exxon appears as a better cash generator than Apple from that metric.

Let me say that one more time: EBITDA distorts the fundamental fact that the capital required to run Exxon's business is significantly greater than the capital required to run Apple's. EBITDA, by including depreciation but excluding capital expenditures, makes Exxon appear "better" the more depreciable assets it has.

The point I am trying to make might be better explained as follows:

  • If a company X earns $100 and it only has $500 of assets (it has no liabilities), it returns 20% on capital.
  • If a company Y earns $100 and it has $1000 of assets (it has no liabilities), it returns only 10% on capital.

The business X would be the better one since it doesn't require as much capital and it therefore earns a better return. In the EBITDA calculation, if both company's assets we depreciated at the same rate, Company Y would look better -- specifically because the depreciation of Company Y's assets would be greater than Company X, and therefore Company Y's EBITDA would be larger than company X. Yet it would still offer a lower return on capital invested.

Saving Us From EBITDA

We have already hinted the simple "cash from operations" is better than EBITDA. So if we take operating cash flow as the metric of cash inflow to the business before purchasing new equipment and other assets -- then we can define the "cash left for shareholders and creditors" as:

Operating Cash Flow - Capital Expenditures

This is one of the common definitions of free cash flow. If we take this argument to its logical conclusion and say that we need to take into account the purchase of new assets, then we find that we must use the free cash flow metric. Applying this to Apple and Exxon, we see the following free cash flow numbers:

AAPL Free Cash Flow TTM Chart

AAPL Free Cash Flow TTM data by YCharts

From all this, we can see that EBITDA made it look as if Exxon produced more cash than Apple. The truth, however, is that while Exxon and Apple receive similar quantities of cash from their ongoing businesses, Exxon must spend a great deal more cash as it attempts to replace its depreciating (and depleting) assets.

This is to say that EBITDA produced the exact opposite of the type of conclusion we, as thorough investors, would like to reach. Apple produces more free cash flow than Exxon. If the two companies were selling for the same price (they are not), Apple would be the better buy.

Seth Klarman Doesn't Approve Of EBITDA

Seth Klarman wrote a section in his book Margin of Safety about EBITDA. It is very appropriately titled: "A Flawed Definition of Cash Flow, EBITDA, Leads to Overvaluation." In it he writes:

"EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow. Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business. To illustrate the confusion caused by EBITDA analysis, consider the example portrayed in [the table below]:

Income Statement for 1990 ($ in millions)

Service Company X Manufacturing Company Y
Revenue $100 $100
Cash Expenses $80 $80
Depreciation and Amortization $0 $20
EBIT $20 $0
EBITA $20 $20
Click to enlarge

Investors relying on EBITDA as their only analytical tool would value these two businesses equally At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing. Although these businesses have identical EBITDA, they are clearly not equally valuable." [1]

Seth Klarman continues on for the entire chapter -- I recommend it.

Warren Buffett Doesn't Approve Of EBITDA

Warren Buffett comments on EBITDA in his 1989 Shareholder letter:

"Soon borrowers found even the new, lax standards intolerably binding. To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay.

Such an attitude is clearly delusional. At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically-calculated depreciation. He would be laughed out of the bank if he started talking about EBDIT.

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…Our advice: Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip your wallet."

He also comments in the 2000 shareholder letter:

"References to EBITDA makes us shudder - does management think the tooth fairy pays for capital expenditures? We're very suspicious of accounting methodology that is vague or unclear, since too often that means that management wishes to hide something."

And in Berkshire Hathaway's Owner s Manual:

"Furthermore, we do not think so-called EBITDA (earnings before interest, taxes, depreciation and amortization) is a meaningful measure of performance. Managements that dismiss the importance of depreciation - and emphasize "cash flow" or EBITDA - are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions"

Conclusion

Do not use EBITDA -- avoid the shallow analysis. Business is a complex affair -- assets must be replaced, inventory levels managed, and accounts collected and paid. While this is not the place to mount a full defense and promotion of free cash flow, the metric offers better insights into the actual cash generation of a business.

Notes:

  1. Klarman, Seth A.. "Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s ." In Margin of safety: risk-averse value investing strategies for the thoughtful investor. New York, N.Y.: HarperBusiness, 1991. 71-78.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.