Warren Buffett - These are the common mistakes when using EBITDA: Part 1

Key takeaways at the end

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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?

2002 Shareholder Letter

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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. [...]

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.

1989 Shareholder Letter

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Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as “EBITDA” and “pro forma”, they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to “restructure” my putting stroke and therefore only count the swings I take before reaching the green.)

2001 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Somewhat good for benchmarking: In my experience, EBITDA is the most (mis)used metric in the financial industry, widely perceived as good for operating performance benchmarking as it ignores differences among accounting standards. That is only somewhat true (I will not bore you with details here). Also, management has some discretion in treating some investments as an expense (lowering EBITDA) or as a capital expenditure (no impact on EBITDA). Moreover, EBITDA is not recognised under either US GAAP or IFRS and therefore offers management discretion to present whatever they want you to believe in. 

• Bad for valuation: By solely looking at EBITDA, you are ignoring expenses that are vital for both maintaining and expanding business operations. EBITDA should be only one of many metrics you look at. Read Part 2 to understand why.