Warren Buffett - These are the common mistakes when using EBITDA: Part 2

Key takeaways at the end

""

Berkshire’s strength comes from its Niagara of diverse earnings delivered after interest costs, taxes and substantial charges for depreciation and amortization (“EBITDA” is a banned measurement at Berkshire).

2023 Shareholder Letter

...

When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test. 

2014 Shareholder Letter

...

When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak. 

2015 Shareholder Letter

...

References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? 

2000 Shareholder Letter

...

Those who believe that EBITDA is in any way equivalent to true earnings are welcome to pick up the tab. 

2001 Shareholder Letter

...

Our definition of [interest] coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure we view as deeply flawed. [...] When Wall Streeters tout EBITDA as a valuation guide, button your wallet. 

2013 Shareholder Letter

...

"Owner earnings" represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges [...] less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). [...]

Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when (c) exceeds (b) - [reported] GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. [...]

[...] All of this points up the absurdity of the "cash flow" [or EBITDA] numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids – forever state-of-the-art, never needing to be replaced, improved or refurbished. [...]

"Cash flow" [or EBITDA] is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays. Why, then, are "cash flow" [or EBITDA] numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). [...]

You shouldn't add (b) without subtracting (c): though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for (c). 

The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring (c) is headed for certain trouble.

1986 Shareholder Letter

* Bold emphasis added

""

Key concepts and takeaways:

• EBITDA ≠ cash flow: I often hear that EBITDA is a good proxy for cash flow. That is deadly wrong. There is a long way to go from EBITDA to the underlying free cash flow generation, which is what ultimately matters when valuing a business. You must consider capital expenditure needed to maintain and expand operations and the need for working capital along the way. Companies also typically pay tax.

• Accounting is backward-looking: D&A reported in the financial statements is based on a cost basis at the time assets was purchased / created, sometimes many years ago. It is highly likely that the expenditure needed to replace that asset in future will be larger than what it was in the past.

• Capital-heavy businesses: EBITDA is most meaningless in retail, manufacturing, utilities, and generally in businesses that need to invest large sums in order to maintain (not even grow) their facilities.