(Editor's Note: This article reflects the views and opinions of Editor Marc Pentacoff and does not reflect the views of Seeking Alpha or its editorial team.)
EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is used as a proxy of the “cash flows” a business produces before paying debt holders, governments and providing for capital investment. By its very definition, EBITDA excludes probable expenses and therefore overstates the amount of cash flow which is actually available to management for free allocation.
Liberty Global (LBTYA, LBTYB,LBTYK) Chairman John Malone, faced with the capital intensive and competitive needs of the early cable industry, was likely the first to introduce EBITDA to Wall Street. Having achieved a total return of 30% annually between 1973 to 1999, his example is worth examining. Net income, for one thing, fails to capture value creation in survival of the fattest growth industries. EBITDA serves as a ‘capital structure neutral’ walking stick when net income, or other measures, do not reflect the value being accumulated or earned.
It is said that EBITDA came of age during the leveraged buyout era of the 1980s since using it as a measure of “repayment capacity” allows for greater leverage. The profitless and sometimes revenueless dot-com boom helped solidified its popularity. Famed value investors like Warren Buffett, Charlie Munger and Seth Klarman opined that EBITDA isn’t actually a cash flow measure and that it greatly overstates cash flow. One Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholder letter notes that Buffett literally “shudders” at its mere mention.
A major use of EBITDA today is in corporate valuations. To use it, one needs an academic idea called “capital structure irrelevance” which states that the total value of a firm is independent of how that firm is financed. This idea is crucial to the now common practice of capitalizing flows of EBITDA to arrive at an enterprise value - that is, as in EV/EBITDA. This particular part of the story, however, requires a future article.
Let’s take a look at a history of this prominent non-GAAP measure.
Net Income or “Residual” versus “Value Accrued”
Old accounting books frequently call net income “residual.” This term better illustrates what net income is - it is the residual amount carried over between periods on the accounting books. It is a reconciliation figure, period to period, for accounting net worth or book value, i.e., shareholder’s equity.
Sometimes the competitive dynamic of an industry is “survival of the fattest.” The biggest will win due to a virtuous cycle of market power through scale. In such a situation it is competitively rational to maximize growth, using up any “residual” which might otherwise exist by spending it on growth projects. In this type of competitive dynamic, management would be rational to maximize growth spending by minimizing tax, by minimizing net income.
Such was the situation faced by John Malone when he joined debt laden cable company TCI in 1973. The term EBITDA was already in the corporate management literature, for instance, in the 1966 textbook The Economics of Corporate Finance but hadn't been used in security analysis. The debt heavy TCI needed to convince analysts to ignore accounting earnings, which were already poor, and argued that those failed to capture the value the firm was creating. The company need to finance its operations with debt, so it could continue to purchase other cable companies and to lay more cable. Malone would say later:
“We became very aggressive in consolidating the cable industry because I saw from the beginning that scale economics was going to determine who was going to survive and who wasn't...We really didn't care about the impact of an acquisition on our earnings, so we would go out and do fairly highly leveraged acquisitions.” (source)
No doubt for reasons of accessing capital, he began advocating EBITDA as a proxy for repayment power - it allowed the “cash flow” of the company to appear healthy, even with losses and large capital spending. “There is a big difference between creating wealth and reporting income,” he would say. The trick, for him, wasn’t net income per say but owning appreciating assets which were then highly leveraged at as low a rate as possible.
Most would argue the next step in the story of EBITDA is in leveraged buyouts - but the leverage buyout era didn’t necessarily need EBITDA. The small 1981 Gibson Greeting Cards leveraged buyout, regarded by some as the starting gun of the era, was consummated because its purchase price was a discount to book value and the lenders looked to good old liquidating value rather than cash flow.
It is said that EBITDA began to be used with depressed and distressed companies in the unusual case of near bankruptcy. Later by banks to evaluate the maximum short-term cash generating ability of a company. Then, the typical story would go, it was applied to capital intensive firms and eventually to all kinds of companies.
As its popularity increased, it began to enter the public discussion. Buffett writes disapprovingly of EBITDA in 1989. The first mention of the term by the New York Times appears in 1991 - it is referred to as the most “liberal definition” of cash flows used by leveraged, money losing companies. Seth Klarman writes about it critically in 1991. With increasing usage throughout the 1990s, its importance in financial culture was crystallized. As is natural in the stock market, the increasing cultural fixation with EBITDA was then exploited in the 2002 Worldcom accounting scandal, the largest financial scandal prior to Madoff.
Till the present, its frequency of usage continued to grow, taking some mind share from official GAAP bottom line - net income.
So how did we get here culturally? The incentives were such that corporate management encouraged it and analysts played along in the social dance. Managements simply made a bigger deal of EBITDA, a non-GAAP measure, and convinced the banks to make loan covenants out of it. The phenomenon of many managements “making a bigger deal” of non-GAAP should sound familiar to investors today. After all, the SEC recently felt it necessary to give more disclosure interpretations regarding non-GAAP. See my article on On GAAP v. non-GAAP for further discussion.
Coming back to John Malone, it is possible that necessity was the mother of invention, or that he is merely the exception which proves the rule, but it is still clear he was creating value without profits. And EBITDA was an attempt to measure this. The traditional value investor critique from Buffett-Munger-Klarman is simple and still correct: it isn’t actually cash flow because it excludes necessary expenses and capital reinvestment.
What these critics may be missing is that GAAP losses do not mean “no value.” GAAP losses just mean no “residual” carried over between periods under accrual accounting. A loss is a very a different fact depending on the circumstances of a specific company. According to Ben Graham, losses are a qualitative, not a quantitative, fact. Losses put a question mark over the business model itself - will they ever be profitable in the future? - whereas from profits one can derive a cash flow schedule from which to value the firm.
EBITDA and Debt
Some uses of EBITDA simply do not seem as useful as their older, more traditional counterparts. Discussing these will showcase the well known shortcomings of EBITDA. For instance:
Debt to EBITDA
EBITDA to Interest
Both metrics ignore the fact that many businesses need constant capital expenditures and increasing levels of working capital for growth - not to mention that interest and taxes are about as certain of expenses as it gets. Therefore, using EBITDA as a meter stick for “debt repayment capacity” nearly always overstates the case and can lead to dangerous conclusions. The fact that Malone, with his 30% annual returns, targeted a debt to EBITDA ratio of 5 should count as an exception - his company paid little in tax and was notoriously skimpy on capex.
There are a few ways to illustrate the problem with EBITDA when it comes to debt. If we assumed, for instance, that Company A has net income of $100, fully converted to cash flow, and has debt of $500, you can say the following:
Company A has a debt to net income ratio of 5 or, in other words, “it would take 5 years to pay off their debt”
With EBITDA, one cannot make claims about the time it would take to pay off the debt. It simply doesn’t proxy for cash flows which are available for debt repayment. That is, it doesn’t proxy for internally generated cash flows available for altering the capital structure.
The only figure which measures internal cash flow available to alter capital structure is free cash flow.
EBITDA versus Free Cash Flow
A further way of illustrating the above issues with EBITDA is to consider a firm which cannot raise money externally. If this company cannot raise capital externally, then only internal cash flows can be used to pay debt, pay dividends, buyback stock or invest in the company.
Internally generated cash is called “cash from operations” in GAAP - it is net income adjusted for non-cash items and working capital demands. Subtracting necessary capital expenditures from this and you are left with the cash which is available to freely alter the capital structure, that is, the cash which is free for debt repayment or anything else management wishes to do.
The above is, of course, the definition of free cash flow, widely considered to be a net income substitute in non-financial firms:
free cash flows = cash from operations - capital expenditures
Using Google’s ngram viewer, you can contrast the popularity of the two metrics:
Further breaking down EBITDA, it is clear why EBITDA “cash flows” cannot be considered free:
Not free since not paying interest is an event of default.
Depreciation & Amortization
Not free in the sense that not reinvesting in most businesses results in a more or less rapid decline in earning power or deterioration of the firm’s property.
Need I mention Max Weber’s definition of the state?
The greatest importance of this distinction is that free cash flow, by definition, is the cash which is internally generated and can be freely used to alter the capital structure of the company. This is the purpose of the term “free.” This makes the best calculation of “years to pay off debt” as:
Debt / avg. free cash flow = years to pay off debt
In most real life situations, a company with a debt to EBITDA of 3 cannot pay off its debt in three years whereas a company with a debt to free cash flow of 3 potentially could. This signals that Debt to EBITDA is nearly non-sensical under its own terms since, depending on the scale of interest and capital expenditures, a debt to EBITDA of 3 could be safe or it could be a danger.
As mentioned, the cultural focus on EBITDA played a notable role in the 2002 Worldcom accounting scandal. Here is the Wall Street Journal’s take from 2002:
“WorldCom said it wrongly treated $3.8 billion in certain operating expenses as capital expenditures. As a result, the costs weren't immediately expensed, as accounting rules dictate such operating costs should be, but were subject to depreciation, under which they gradually would be run through the income statement as an expense.
While the move enhanced the company's net income, it had an even more dramatic impact on Ebitda, as depreciation costs, of course, are totally excluded. Voila -- the entire $3.8 billion in operating expense disappeared from investors' radar screens.” (Wall Street Journal)
The scandal generated some soul searching regarding EBITDA among analysts but, as history shows, few hearts were changed. The problem back then is similar to the problem today - non-GAAP measures were being accepted by analysts without critical reflection.
Capital Structure Irrelevance
It is also worth meditating on how EBITDA is being used today, not simply by managements wishing to communicate in non-GAAP, but to value firms. This latter process requires a theory where one can value bonds and stocks at the same time using a single discount rate. This, however, needs to be treated at length and requires breaking the subject into a separate article. Please stay tuned for part two in coming weeks.
The old line value investors missed something in their critique of EBITDA. They ignore that market share gains in a survival of the fattest industry dynamic is a form of value creation - even if there is no “residual” period to period. EBITDA can give a performance picture when traditional metrics are negative.
Yet it isn’t a measure of the cash which is available to alter the capital structure - this indicates that the perception that it is “cash flow” is overstated. This can have serious implications when it is used to measure repayment capacity as in the popular metrics of debt-to-EBITDA or EBITDA-to-interest. These metrics are so abstracted from the capital structure and capital requirements of a business that, in my view, they are more trouble than they are worth.
Disclosure: I am/we are long SPY, BRK.B.
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.
Disclosure: I am/we are long BRK.B, SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.