The term earnings before interest, taxes, depreciation, and amortization (EBITDA) has gotten extraordinarily popular over the last few decades. Companies will often comment on EBITDA in their management discussion and analysis (MD&A), especially when they talk about debt and financial leverage. But as an equity investor, should I really care what EBITDA is?
EBITDA does provide an equal footing to compare profitability across companies before considering interest, taxes, depreciation, and amortization.
However, EBITDA does not represent actual cash that is available to be returned to shareholders; which is what being a shareholder is all about.
| EBITDA | = | Net Income |
| + | Interest | |
| + | Tax | |
| + | Depreciation | |
| + | Amortization | |
EBITDA is a non-GAAP (generally accepted accounting principles) term and you will never see it on the face of the financial statements for this reason. When management goes to great lengths to discuss EBITDA rather than net income, this should be viewed with skepticism and investors should not lose sight of the bottom line net income. This point of view is being made widely known by Charlie Munger, vice chairman of Berkshire Hathaway, who openly refers to EBITDA as “bulls**t earnings”.
The EBITDA metric got popular during the 1980’s leveraged buyout craze as private equity investors used it to assess how much debt a company could handle. But unless you are a private equity investor able to buy out a business and its debts entirely in order to re-leverage it the way you want, pick it up and move it to a different tax jurisdiction, and turn off spending on capital expenditures, EBITDA is really not that meaningful to the average equity investor. That being said, let’s take a look at what EBITDA is backing out to get a better understanding of what it means.
Interest Varies with Capital Structure
Adding back interest expense to net income shows the earnings that would be available to all investors of capital; both debt and equity investors. Analyzing a company before interest expense shows the unleveraged earnings power of the business and allows for good comparison opportunities between industry competitors. That being said, it is rather unusual to see a company operate with no financial leverage and retail investors are in no position to change a company’s capital structure.
Taxes are Inevitable Cash Expenses
Unless a business is unprofitable, taxes will unfortunately have to be paid. Taxes are a cash expense that need to be paid annually to the government and as such are not available to be returned to shareholders. In terms of materiality, taxes are hugely material ranging from highs of 34.4% statutory tax rates in France to lows 9.0% in Hungary with a weighted average rate of among OECD countries of 26.5%. The U.S. falls right around this average at 25.7% in 2018 after the Tax Cuts and Jobs Act (TCJA) reduced the U.S. federal corporate income tax rate from 35% to 21% but was 38.9% before TCJA. Do note that the statutory rate is higher than the federal rate as it includes state taxes as well.
Depreciation is Historic Cash Capital Expenditures
While depreciation might seem like a non-cash expense at first glance, it actually represents capital expenditures on physical assets that were made in prior years being expensed off the balance sheet. This means that not only does deprecation represent a real cash outlay, but since the cash was paid upfront in one lump sum, it is even less favourable than a regular cash expense in because of present value effects. Warren Buffett made his thoughts on depreciation clear in his 2013 shareholder letter with the below quote.
“Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet”
Warren Buffett
For asset heavy businesses (such as manufacturing) depreciation can represent hugely material amounts of net income.
The major benefit to adding back depreciation to earnings is to make comparisons across industry competitors. While the useful lives of similar assets should be relatively consistent between industry competitors, looking at net income before depreciation will help put competitors on equal footings.
Side Note: Depreciation will normally be lower than capital expenditures even in a no-growth business due to inflation. This means that the same asset being depreciated will have a higher price today than the historic value being depreciated.
Amortization Is Not Always A Real Expense
Amortization represents the usage and expense of intangible assets (non-physical assets unlike depreciation) such as software, patents, licenses, and customer lists. These intangible assets could have been developed internally or purchased through the acquisition of another business. In either case, there was a real cash outlay for these assets when the intangible asset was internally developed or purchased from another business.
Most intangible assets are truly wasting assets that lose value over their useful life such as software that becomes obsolete or patents that lose their exclusivity. However, some other intangible assets (such as customer lists) which are given value under purchase accounting rules when a business is acquired, might not actually represent a wasting asset that needs to be amortized. Warren Buffet made his thoughts clear on when amortization is not a relevant expense in his 2013 shareholder letter as well.
“In the GAAP-compliant figures we show on page 29, amortization charges of $648 million for the companies included in this section are deducted as expenses. We would call about 20% of these “real,” the rest not. This difference has become significant because of the many acquisitions we have made.”
Warren Buffett
Takeaway
EBITDA is a non-GAAP financial metric that needs to be viewed with skepticism when being touted by company management and analysts. EBITDA can be useful in comparing industry competitors on an equal footing before taking into account leverage, taxes, and the useful lives of assets.
However, with the exception of certain amortization expenses, the items being backed out of EBITDA are real cash expenses that are not available for distribution to equity shareholders. Be careful to never lose sight of the bottom line which is GAAP net income.
