Once upon a time, not so long ago in a land called Wall Street, a tribe known as the Investment Bankers devised the ultimate hoodwink in an attempt to justify increasingly risky and expensive deals. They called their creation – EBITDA
“I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”
“References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures?”
– Warren Buffett
Earnings Before I tricked the Dumb Auditor Earnings Before Interest, Depreciation & Amortization is an oft touted metric of a company’s performance, and is typically used in the acquisition multiplier
EV / EBITDA where Enterprise value = Market Value of Debt + Market Value of Equity + Minority Interest - Cash & Cash Equivalents
Private Equity firms love EBITDA because they have an incentive to make a company look as good as possible. EBITDA is a nice pretty multiplier because it conveniently sweeps under the rug some very real costs – interest costs (debt is rented capital after all), tax costs (somebody has to pay the tax man) and maintenance capital expenditure (the cost incurred by companies to maintain their “steady state” current position by replacing existing assets). Using EBITDA as a proxy for cash flows can thus make interest coverage look better and make the firm look less leveraged.
To that end, implying that depreciation is a non-cash charge therefore it should not be considered is also flawed. It is a capital expenditure that represents a cash expense up front, only it is recorded in a delayed manner and the benefits show up at a later date.
(A) Capital Intensive businesses are given a free pass where their capex is wished away with a swipe of an excel wand. Not only do businesses often need to reinvest to maintain their current plants and machinery, depreciation may understate this aspect as they need to do so in current currency terms, which inflation has increased since the original capex was made
(B) Changes in Working Capital are unaccounted for. Not only do additional investments in working capital consume cash, changes in the cash conversion cycle – increases in account receivable period and / or decrease in accounts payable period can cause a company to report a profit but be consuming cash instead.
Exhibit – Telecom company (notoriously capex intensive sector)
It should be fairly obvious here that if you were to merely look in EBITDA terms, the company APPEARS cheap and the EBITDA margins look fantastic. However, when you peer down at the ROE, interest, depreciation and tax costs, a completely different tale is told.
The next time anyone (management, analysts etc) tries to highlight the EBITDA of a company, the appropriate response is immediate skepticism and a prompt look under the hood.