EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” It is one of many indicators of a company’s financial performance; however, it excludes depreciation and amortization on the basis that they are “non-cash items.” Depreciation and amortization are also a measure of what the company is spending or needs to spend on capital expenditure to maintain or grow the business. So although EBITDA is used as a measurement of a company’s earning potential, it does not account for the cost of debt capital or its tax effects.
A company that spends zero money on capital expenditures could be well suited to use EBITDA metrics as the non-cash depreciation and amortization part does not have to be replaced with CapEx – but this applies to almost no businesses. Companies who have large amounts of fixed assets subject to heavy depreciation charges, or who have acquired intangible assets on their books and are thus subject to large amortization charges use this EBITDA when measuring their earnings. Creditors also often use this measurement.
Warren Buffett shares some of his thoughts on EBITDA:
“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.”
“We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report.”
“The tooth fairy pays for capital expenditures?”
Warren Buffett is credited with having said, “Does management think the tooth fairy pays for capital expenditures?”
EBITDA is used to analyze and compare the profitability between different companies in the same industry as it eliminates financing effects and accounting decisions. Many times, a company changes the items included in their EBITDA metric calculation from one reporting period to the next. Because of this, Warren Buffett does not think that it is a true representation of the company’s performance financially.
In other words, Mr. Buffett is pointing at the fault of using EBITDA metrics in that they exclude depreciation and amortization as a means of valuing the company. Although the depreciation and amortization expense is not an actual cash outflow, it does, in effect, reduce the value of a company’s total assets through reducing the value of specific capital and/or financial assets. This reduction in value is intended to closely mimic the true nature and value of the asset.
As an example, imagine a company that has no other assets other than multiple factories under its Property, Plant, and Equipment asset account. Naturally, over time, these factories would lose value as they age and are used up. Using EBITDA as a means of valuing this company would be entirely fallacious, as it would not account for the loss in value that the factories are experiencing. Using EBITDA, in this case, would overstate the company’s earnings, and thus, overstate their value.
This has been a guide to Warren Buffett on the topic of EBITDA, and the reason why it isn’t always a good valuation metric. To keep learning and progressing your skills, check out these additional resources: