Why is EBITDA popular?

Hey guys I am just a little confused why EBITDA is used so much? I understand it may be appropriate to ignore depreciation charges when valuing certain companies but why would you ignore interest and tax payments? These charges are real cash outflows that cannot be avoided so I am curious what the value of EBITDA is?

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Comments (76)

Best Response
May 20, 2011 - 5:34pm

EBITDA (in theory) reflects the operating income of the firm without being influenced by "non-operating" things like capital spending decisions (D&A/tax expense), financing decisions (interest expense/tax expense), and accounting treatment of D&A (taxes), which usually doesn't reflect replacement capex requirements. This is important both for planning/analysis purposes and because income statement taxes (often) and interest expense (sometimes) don't reflect cash expense. Therefore, it's helpful because two firms with different capital structures, tax treatments, etc can be compared somewhat more easily.

EBITDA does have its detractors. Steve Wynn often complains about people using EBITDA to value capex-intensive businesses like casinos, as an example. We often use EBITDA-Maintenance capex to adjust for this; most professional investors also use cash flow metrics in their valuations and perform additional pro-forma changes to make comparisons apples to apples.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
  • 8
May 20, 2011 - 5:41pm
Kenny_Powers_CFA:
EBITDA (in theory) reflects the operating income of the firm without being influenced by "non-operating" things like capital spending decisions (D&A/tax expense), financing decisions (interest expense/tax expense), and accounting treatment of D&A (taxes), which usually doesn't reflect replacement capex requirements. This is important both for planning/analysis purposes and because income statement taxes (often) and interest expense (sometimes) don't reflect cash expense. Therefore, it's helpful because two firms with different capital structures, tax treatments, etc can be compared somewhat more easily.

EBITDA does have its detractors. Steve Wynn often complains about people using EBITDA to value capex-intensive businesses like casinos, as an example. We often use EBITDA-Maintenance capex to adjust for this; most professional investors also use cash flow metrics in their valuations and perform additional pro-forma changes to make comparisons apples to apples.

Thanks for the explanation kenny. Can you explain why tax and interest charges on the income statement may not reflect the actual cash expense?

May 20, 2011 - 5:50pm
egg and cheese:
Kenny_Powers_CFA:
EBITDA (in theory) reflects the operating income of the firm without being influenced by "non-operating" things like capital spending decisions (D&A/tax expense), financing decisions (interest expense/tax expense), and accounting treatment of D&A (taxes), which usually doesn't reflect replacement capex requirements. This is important both for planning/analysis purposes and because income statement taxes (often) and interest expense (sometimes) don't reflect cash expense. Therefore, it's helpful because two firms with different capital structures, tax treatments, etc can be compared somewhat more easily.

EBITDA does have its detractors. Steve Wynn often complains about people using EBITDA to value capex-intensive businesses like casinos, as an example. We often use EBITDA-Maintenance capex to adjust for this; most professional investors also use cash flow metrics in their valuations and perform additional pro-forma changes to make comparisons apples to apples.

Thanks for the explanation kenny. Can you explain why tax and interest charges on the income statement may not reflect the actual cash expense?


Another quick explanation of this: book depreciation vs tax depreciation may be different.
Basically, even though you may be depreciating an asset based on GAAP rules, the jurisdiction you're in may have different depreciation rules with regards to tax benefits. Since D&A flows down through tax, the taxes that you might expense on your income statement will be different than the actual taxes you pay to the government.
Now i really need to get back to work.
  • 2
May 20, 2011 - 5:37pm

EBITDA gives you the effective cash flow of the company before the effects of capital structure and tax jurisdiction (both of which are choices, more or less). Thats why you use enterprise value for the mutliple as that is the value of the company regardless of cap structure. EBITDA is also used as a rough proxy for cash flow.

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May 20, 2011 - 5:43pm

Im going to give you a quick explanation. Im sure you can google this though.
From a valuation perspective, slapping a multiple onto EBITDA would give you a better estimate of the value of a company. Reason being, EBITDA is a good proxy of the operating performance of an asset (ie: a company), because it excludes things like capital structure (ie: the debt a company has) which shouldn't really effect the value of a company that much. If you were to include, lets say, interest in EBITDA, you are factoring in the capital structure.

Very simple, but quick example: you have 2 assets. they are both similar. both earn EBITDAs of $100m. however, one has some debt (hence, interest payments), the other has none. Lets say this type of asset is valued at 10.0x. Hence, both assets will be valued @ $1b using an EBITDA of $100m. However, if we go by what you're saying, and include interest, well, now we can't really compare the 2 anymore because one has interest payments, while the other doesnt...becomes a bit more complicated to value them properly.

hope that made sense...back to work...

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May 22, 2011 - 6:59pm
Mezz:
Im going to give you a quick explanation. Im sure you can google this though.
From a valuation perspective, slapping a multiple onto EBITDA would give you a better estimate of the value of a company. Reason being, EBITDA is a good proxy of the operating performance of an asset (ie: a company), because it excludes things like capital structure (ie: the debt a company has) which shouldn't really effect the value of a company that much. If you were to include, lets say, interest in EBITDA, you are factoring in the capital structure.

Very simple, but quick example: you have 2 assets. they are both similar. both earn EBITDAs of $100m. however, one has some debt (hence, interest payments), the other has none. Lets say this type of asset is valued at 10.0x. Hence, both assets will be valued @ $1b using an EBITDA of $100m. However, if we go by what you're saying, and include interest, well, now we can't really compare the 2 anymore because one has interest payments, while the other doesnt...becomes a bit more complicated to value them properly.

hope that made sense...back to work...

True, however, as someone noted above and Buffet has said (paraphrasing) "Who's going to pay for D&A? It's not a made up expense,". Like adj. for non recurring items, I have issue w/ the fact the even tho one can theoretically back out of these expenses, every company can/does/and will have to account/pay for these line items one way or another. They're real issues when operating and trying to drive profitability for a company so the "instrinsic" value of these metrics should be taken with a grain of hefty salt as an investor, IMHO.

Ace all your PE interview questions with the WSO Private Equity Prep Pack: http://www.wallstreetoasis.com/guide/private-equity-interview-prep-questions
  • 2
May 22, 2011 - 7:15pm
Stringer Bell:
True, however, as someone noted above and Buffet has said (paraphrasing) "Who's going to pay for D&A? It's not a made up expense,". Like adj. for non recurring items, I have issue w/ the fact the even tho one can theoretically back out of these expenses, every company can/does/and will have to account/pay for these line items one way or another. They're real issues when operating and trying to drive profitability for a company so the "instrinsic" value of these metrics should be taken with a grain of hefty salt as an investor, IMHO.

The point is a good one but it assumes that D&A are a good proxy for capex needs. EBITDA-Capex at least uses real current capex, as opposed to EBIT which uses an accounting metric only partially related to real changes in value and often influenced by tax considerations.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
  • 2
May 20, 2011 - 5:53pm
zoomi:
Why not use a GAP number like Cash From Operations and simply add back interest and taxes?

CFO is going to reflect non-operating expenses because it starts for Net Income and then adjustes for non-cash charges, accruals, and change in W/C. The point is to get an idea for operational margins. If you start adding back too much stuff you're just going to get back to EBITDA anyway.
There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
  • 1
May 20, 2011 - 5:59pm

Agree with Kenny - remember that while EBITDA is good to compare the valuations of different companies, EBITDA IS NOT a good proxy for cash flow. Depreciation is probably the worst kind of expense- you outlay a bunch of cash right away before the asset has done anything and don't get the tax benefits until later (assuming you are even profitable).

And remember - virtually every company must spend some type of money to maintain their competitive position. Most of the time, this cash that must be spent is in the form of CAPEX (maintenance capex) to replenish assets. If you don't replenish your assets, you will be losing ground to competitors that are spending necessary maintenance capex, you will not be able to generate as much cash as in previous years, and you will effectively slowly liquidating yourself.

So yes, EV/EBITDA multiples can be a good quick way to look at the trading value of a firm, but don't assume it's a proxy for cash flow.

May 22, 2011 - 7:10pm
Cries:
then why is minority interest constantly quoted as being part of EV?

EV is thought to be a better proxy to investors due to who get's what. Market cap reflects value to the universe of those who hold any type of equity, visa vi, common stock holders all the way to board members. EV takes into account the "guts" or "core" of a company by adding debt and removing exsisting cash, and makes the case as the value of the actual business and operation of [ ] business, hence the name Enterprise value.

That said, minority interest such as JV's and other ancillary ownership are part of overall influence and ownership of the company. EV try's to remove the effects of common, non-primary, ownership of the company. In a nut shell, EV is the value that equity holder would potentially gain (loss) from direct operational/company performance, or you could value gained (loss) in a vaccum.

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  • 3
May 22, 2011 - 4:31pm

Because it IS part of EV. EV is the whole firm, not just the value of a given security. Here's from Wikipedia:

Enterprise value =
common equity at market value
+ debt at market value
+ minority interest at market value, if any
– associate company at market value, if any
+ preferred equity at market value
– cash and cash-equivalents.

If you're using an EBITDA multiple, the value reflects the entire firm's earnings, and you need to back out the portion of the EV that doesn't "belong" to the common share holders.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
  • 4
May 29, 2011 - 8:59am
Kenny_Powers_CFA:
Because it IS part of EV. EV is the whole firm, not just the value of a given security. Here's from Wikipedia:

Enterprise value =
common equity at market value
+ debt at market value
+ minority interest at market value, if any
– associate company at market value, if any
+ preferred equity at market value
– cash and cash-equivalents.

If you're using an EBITDA multiple, the value reflects the entire firm's earnings, and you need to back out the portion of the EV that doesn't "belong" to the common share holders.

Why the formula of EV include - associate company at mv, if any. If this is true, why not exclude the joint venture at MV, if any?

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  • 2
May 29, 2011 - 9:24am
skyyanforever:
Why the formula of EV include - associate company at mv, if any. If this is true, why not exclude the joint venture at MV, if any?

Remember that EV stands for ENTERPRISE value. JV is the portion of the ENTERPRISE owned by other stakeholders, so it's added back. Associate companies are stakes in OTHER ENTERPRISES owned by the company, so it's subtracted out.

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  • 1
May 22, 2011 - 6:33pm

Heh, thanks.

It registers in my brain now. SB for you :D

Array

May 26, 2011 - 4:18pm

How useful EBITDA is depends on what kind of company you're looking at and what kind of investor you are. If you are an equity investor you should care about owner earnings aka long-term cash flows to equity holders that take into account "true" CapEx. Thus, you won't really be interested in EBIT or EBITDA, unless the company has a debt/liquidity problem.

If you are a debt investor, clearly cash flow is your number one priority and EBITDA is sometimes a good proxy for that if the company records D&A/CapEx properly, otherwise you will have to make your own adjustments.

May 30, 2011 - 9:09am

I'm sorry, I meant minority interest rather than JV.

Minority interest represents value associated with the enterprise being valued that is not owned by the common shareholders, so it is added back when valuing the enterprise. Investments in associates (basically minority interest investments in other companies) is value owned by by the common shareholders but not associated with the enterprise (ie the opposite of minority interest).

Remember this is the strict financial-theory definition of enterprise value. If you're trying to, say, value a share of common stock, you want to leave in the value of investments in associates (because that value accrues to common shareholders-Yahoo's investments in Asia, such as Alipay, are good examples of this-investors in Yahoo put material value on their investment in associates [http://seekingalpha.com/article/272380-alipay-fiasco-underscores-the-ex…]) but also make sure to reflect the minority interest, because that portion of the equity value is owned separate from the common.

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
  • 3
May 30, 2011 - 10:36am
Kenny_Powers_CFA:
I'm sorry, I meant minority interest rather than JV.

Minority interest represents value associated with the enterprise being valued that is not owned by the common shareholders, so it is added back when valuing the enterprise. Investments in associates (basically minority interest investments in other companies) is value owned by by the common shareholders but not associated with the enterprise (ie the opposite of minority interest).

Remember this is the strict financial-theory definition of enterprise value. If you're trying to, say, value a share of common stock, you want to leave in the value of investments in associates (because that value accrues to common shareholders-Yahoo's investments in Asia, such as Alipay, are good examples of this-investors in Yahoo put material value on their investment in associates [http://seekingalpha.com/article/272380-alipay-fiasco-underscores-the-ex…]) but also make sure to reflect the minority interest, because that portion of the equity value is owned separate from the common.

O, ic ic. I got your point. So the Yahoo's investment in Alipay gives itself a lot of positive support to its mkt cap (e.g. share price), while as it is just an inv't in associate, it should be excluded for the calculation of Yahoo's EV.

Thanks man

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  • 2
Jun 1, 2011 - 10:53am

Hello,

Your question is so valuable. In currently EBITDA became popular and was used to gauge a company's ability to service debt. This is because depreciation and amortization are non-cash charges and do not affect a company's ability to generate money that could be used to pay off interest of loans or to retire debt.

Thanks a lot
Sean Kingston

Jun 2, 2011 - 12:44am
Sean Kingston:
Hello,

Your question is so valuable. In currently EBITDA became popular and was used to gauge a company's ability to service debt. This is because depreciation and amortization are non-cash charges and do not affect a company's ability to generate money that could be used to pay off interest of loans or to retire debt.

Thanks a lot
Sean Kingston


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  • 1
Jun 2, 2011 - 1:35am

You forget that you need gas to turn. It goes against your natural instinct.

I think that we are all clinging to a great many piano tops...
Jun 2, 2011 - 8:11am

Can we learn more at DoSomething.org?

There have been many great comebacks throughout history. Jesus was dead but then came back as an all-powerful God-Zombie.
Aug 23, 2013 - 12:05am

EBITDA is most useful in intra-industry comparative analysis:

"Earnings" - which in the long run are equal to Cash Flow
"Before Interest" - when unlevered cash flows are capitalized at the weighted average cost of capital, the resulting Enterprise Value is free from the distortion created by varying capital structures.
"Taxes" - To prevent distortion from different tax regimes, accounting conventions and deferred tax assets/liabilities.
"Depreciation & Amortization" - To prevent distortions from accounting conventions, management estimates and the relative age of PP&E.

As an example, consider two movie theatres, both with 10 locations and 150 screens. Company A has a D/E ratio of 1.5:1 and Company B has a D/E ratio 0.5:1. However, Company A has new, state of the art digital projectors and stadium seating while company B has old, analog projectors and sloped floors. Both show the same net profit of $1 million. Which should you invest in?

Clearly Company A has a higher Interest expense and D&A expense than Company B, and therefore a higher EBITDA. Capitalizing both EBITDA's at multiples that reflect there respective risks will produce their respective Enterprise Values. From there, backing out the amount of debt each company actually has on its B/S will produce Equity Values that can be compared.

In other words, its possible that Company A has a higher D/E because it financed major CAPEX, while Company B did not update its PP&E and therefore understandably has a better D/E. Unless you put the companies on equal footing, you really can't compare the two.

Aug 23, 2013 - 1:49am

Sorry to hijack, but this is a good thread. Thanks for helping out uninformed monkeys like myself, guys.

dollas
Aug 23, 2013 - 1:51am

EBITDA is a proxy for cash flow.

D&A are non-cash expenses so you need to rip them out, hence, get a better estimate of a firm's CF.

  • 1
Aug 23, 2013 - 1:54am

Cash from Operations --> easily effected by one time changes such as altering inventory or a big change in deferred revenue.

EBITDA --> better proxy for ongoing operating cash flow.

However, you need to consider when to use each one.

I would never use EBITDA for Apple because 80%+ of iPhone revenue shows up in the Cash Flow from Ops and not the income statement.

Use EBITDA for companies with big capital requirements (Alcoa, United Tech, Boeing, anything Retail).

In the end, they both should be taken with a grain of salt since capex is not taken into account. Free Cash Flow wins the day.

Aug 23, 2013 - 1:55am

EBITDA is used to compare companies b/c they can't individually manipulate it. Just like a company can get creative with it's capital structure and tax position (affecting interest exp and taxes), it can get creative with how it depreciates assets and amortizes expenses. EBITDA filters that out and gives you a clearer comparison.

Aug 23, 2013 - 1:57am

EBITDA became popular in the 70s and 80s when buyout shops were trying to locate companies that had strong cash flow outside of financing and capex concerns. Since the LBO shop was going to change the cap structure anyway, it was convenient to have a quick apples to apples comparison. Also, since the plan in a buyout is to lever the shit out of the company, halt all meaningful capex, and pay down debt with every available dollar of FCF, EBITDA shows you what cash flow would be if no more capex was required to run the business. Getting taxes out of there is useful as well since the LBO shop shop will probably figure out a way not to pay them.

Aug 23, 2013 - 1:58am

This isn't entirely correct. EBITDA is a great proxy for cash flow as it is independent of capital structure (aka -- regardless of how much debt you put on the company, it won't alter its EBITDA). As mentioned above, cash flow from operations is what the LBO shops are looking for. Essentially, LBO shops want to know how much cash the company is going to generate going forward. If your WC dropped substantially in 1 year, this will generate a lot of cash, but it doesn't reflect the ongoing cash generating potential of the company.

I disagree with jhoratio that LBO shops are looking to "lever the shit out of the company, halt all meaningful capex and pay down debt with every available dollar of FCF." While there are a select few shops that may have this objective, the two largest drivers of returns are sale multiple expansion and EBITDA growth. To achieve these, you need to continue to make capital investments and improve the business (or just get lucky...). Simply drawing out every dollar possible to pay down debt is unlikely to maximize value.

CompBanker

  • 4
Aug 23, 2013 - 1:59am

Feel free to correct me if I am wrong here....

I think he was referring to the LBO tactics in the 1980's.

Back then, they would lever until all of EBITDA went to interest payments, thereby leaving no room for D&A. Taxes were minimal or zero since your interest expense essentially reduced pretax income to zero.

Part of the assumptions back in the 80's was that they could reduce capex, so the allowance from D&A was not necessary. They would just take the D&A allowance and use it for interest payments.

However, the capex was needed, and many companies ended up going bankrupt because they did not have the free cash flow to handle it (all of it was going to existing interest payments).

Aug 23, 2013 - 2:00am

FCF needs to be adjusted for non cash flow items such as D&A and provisions. D&A are costs and therefore occur on the P&L, but are however not cash outflows (capex represents cash outflows for fixed assets). This has purely to do with accounting rules with respect to tangible/intangible fixed assets (except for goodwill which goes through impairments).

Why EBITDA is a good proxy for FCF is because it is independent of capital structure (as stated above) and it 'adjusts' for different tax regimes and D&A methods, so you are able to compare apples with apples.

Aug 23, 2013 - 2:02am

Use of EBITDA - Sensible or Flawed? (Originally Posted: 03/04/2014)

Earlier today I was reading Buffet's 2013 annual letter to shareholders of Berkshire Hathaway, and one tiny, miniscule point caught my eye:

Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure we view as seriously flawed.

Well, EBITDA forms the basis of a lot of analysis done at my fund, for reasons I went into in an older post of mine. And yes, my fund uses EBITDA only for determining interest and debt coverage ratios.

What is the flaw in using EBITDA? For what purposes would EBITDA be considered as a useful metric? Happy to hear both sides of the argument. Thanks a lot!

Move along, nothing to see here.
  • 5
Aug 23, 2013 - 2:03am

For what it's worth this is nothing new for the Buffett crowd - a quote from Charlie Munger: "I think that, every time you see the word EBITDA, you should substitute the words "bullshit earnings".

From the glossary of Seth Klarman's Margin of Safety: "Earnings before interest, taxes, depreciation, and amortization (EBITDA)-a nonsensical number thought by some investors to represent the cash flow of a business"

I would imagine EBITDA is used so often despite it's shortcomings because 1) it's easy, and "smooth" compared to other forms of earnings/cash flow, 2) it simply became convention during the 80s buyout boom. On the second point, I think EBITDA, or at least EBITA, made more sense back then because anytime you bought a company goodwill was amortized for book earnings. And while it's dangerous to regard depreciation as "non-cash" because machines need to be replaced, amortization of goodwill was clearly a non-cash charge that made sense to add back when comparing companies.

The way I think about it is there are three things between EBITDA and before interest free cash flow - capex, working capital, and taxes. Clearly these three things can vary tremendously, and permanently, between companies in different industries and even for companies within the same industry, which may be regarded as comps. Thus the conversion rate from EBITDA to UFCF will vary a lot across businesses. Since cash flow is what you care about as an owner, and EBITDA does not translate to cash flow at a uniform rate across firms, using EBITDA multiples as a valuation tool is dangerous. In addition, levered free cash flow is your best yardstick as an equity investor, and that will be influenced by capital structure, which again varies across firms and is not well represented when looking on an EV/EBITDA basis.

I have zero exposure to PE and you're a second year analyst so I can't comment there. My guess would be EBITDA is a slightly better yardstick in PE vs public markets investing because control of a company gives you some ability to influence a) PPE & working capital investment, b) capital structure. So if you think that capital expenditures, investments in working capital, and capital structure are items you will be controlling, then in comparing two companies it might make sense to look at what earnings/cash flow is *before* these items are taken into account. Whereas as a public equity investor, capex, WC, and capital structure are *features* of the company I am buying that I cannot change, and must be taken into account.

Aug 23, 2013 - 2:05am

Great response, what you said makes perfect sense. I should mention that we use EBITDA in conjunction with FCFF, where like you said, its ultimately FCFF which is our king. Also, your other point stands true as well - being operational investors, we do control capex and have reasonable control over working capital management.

However, Buffet apparently uses pre-tax earnings for determining interest coverage, which doesn't include capex and working capital either. While earnings before interest may have its advantages over EBITDA (since it includes depreciation), it still doesn't explain what makes pre-tax earnings Buffet's preferred measure.

Move along, nothing to see here.
  • 2
Aug 23, 2013 - 2:08am

Extelleron:

For what it's worth this is nothing new for the Buffett crowd - a quote from Charlie Munger: "I think that, every time you see the word EBITDA, you should substitute the words "bullshit earnings".

From the glossary of Seth Klarman's Margin of Safety: "Earnings before interest, taxes, depreciation, and amortization (EBITDA)-a nonsensical number thought by some investors to represent the cash flow of a business"

I would imagine EBITDA is used so often despite it's shortcomings because 1) it's easy, and "smooth" compared to other forms of earnings/cash flow, 2) it simply became convention during the 80s buyout boom. On the second point, I think EBITDA, or at least EBITA, made more sense back then because anytime you bought a company goodwill was amortized for book earnings. And while it's dangerous to regard depreciation as "non-cash" because machines need to be replaced, amortization of goodwill was clearly a non-cash charge that made sense to add back when comparing companies.

The way I think about it is there are three things between EBITDA and before interest free cash flow - capex, working capital, and taxes. Clearly these three things can vary tremendously, and permanently, between companies in different industries and even for companies within the same industry, which may be regarded as comps. Thus the conversion rate from EBITDA to UFCF will vary a lot across businesses. Since cash flow is what you care about as an owner, and EBITDA does not translate to cash flow at a uniform rate across firms, using EBITDA multiples as a valuation tool is dangerous. In addition, levered free cash flow is your best yardstick as an equity investor, and that will be influenced by capital structure, which again varies across firms and is not well represented when looking on an EV/EBITDA basis.

I have zero exposure to PE and you're a second year analyst so I can't comment there. My guess would be EBITDA is a slightly better yardstick in PE vs public markets investing because control of a company gives you some ability to influence a) PPE & working capital investment, b) capital structure. So if you think that capital expenditures, investments in working capital, and capital structure are items you will be controlling, then in comparing two companies it might make sense to look at what earnings/cash flow is *before* these items are taken into account. Whereas as a public equity investor, capex, WC, and capital structure are *features* of the company I am buying that I cannot change, and must be taken into account.

This is pretty much what Buffett himself has said on the matter:

We'll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they're trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don't get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them.

Of course the point of excluding interest and taxes is that these are dependent upon the prevailing capital structure, and therefore not an apples-to-apples comparison between companies, much less industries. From a private equity perspective the capital structure (and therefore tax/interest burden) will change upon acquisition, so these are modeled out in the projections based a starting and projected/changing capital structure. So from that perspective what he's saying doesn't carry much weight.

Regarding depreciation, Buffett has also said this:

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?

But it's my understanding that such cash expenses, when modeled out, are reflected in the form of CapEx, SG&A, etc. and that EBITDA isn't an actual proxy for cash flow because of these characteristics, no?

Aug 23, 2013 - 2:04am

I'm confused by the Buffet quote; if you're looking at your coverage ratio, why would you use pretax earnings (which is after interest expenses) to interest? Isn't that redundant?

Isn't EBIT/interest the most conventional coverage ratio?

People demand freedom of speech as a compensation for freedom of thought which they seldom use.
Aug 23, 2013 - 2:06am

Anihilist:

I'm confused by the Buffet quote; if you're looking at your coverage ratio, why would you use pretax earnings (which is after interest expenses) to interest? Isn't that redundant?

My thoughts exactly. I just put it down to some weird "conservative scenario" coverage on their part.

Move along, nothing to see here.
  • 1
Aug 23, 2013 - 2:13am

Going Concern:

I've seen [EBITDA - Capex] used as a proxy for FCF.

Also I really despise how pretentious fin-ance people say EBITDA, with emphasis on the "DA".

Brilliant. Get a bunch of MDs in a room discussing EBITDA, and you'll see more spittle shooting across the room than in a nursing home.

Aug 23, 2013 - 2:19am

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Move along, nothing to see here.
Aug 23, 2013 - 2:21am

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Blue horseshoe loves Anacott Steel
Aug 23, 2013 - 2:22am

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[quote=patternfinder]

Of course, I would just buy in scales.

[/quote]

See my WSO Blog | my AMA

Aug 23, 2013 - 2:25am

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