It’s fair to say earnings before interest, tax, depreciation and amortisation (EBITDA for short) is not universally popular as a measure of earnings.

It has some notably high-profile detractors in the form of Warren Buffett and his late business partner Charlie Munger. Munger even crudely observed EBITDA earnings should be characterised as cow-pat earnings, although he didn’t use the words cow or pat.

In this article we will take a closer look at EBITDA, discussing its limitations but also how it can be useful to investors if employed sensibly.

WHAT IS EBITDA?

EBITDA is sometime characterised as being a proxy for the cash generated by a business. This is because it removes the effect of non-cash expenses such as depreciation and amortisation. In theory these non-cash items are of less significance to an investor because they are ultimately interested in the cash flows of a business.

EBITDA is often used when looking at businesses with lots of plants and machinery which have significant associated non-cash deprecation costs, which might obscure the underlying performance, as well as technology firms which amortise the cost of software development and other intellectual property.

However, it fails to take account of the fact depreciation, in particular – which measures the decrease in loss or value of an asset over time due to age, wear or market conditions – is a very real cost of doing business in a lot of sectors and should therefore be taken into account when analysing them.

WHY DOES BUFFETT HATE IT?

Crystalising this point, a key charge levelled at EBITDA, including by Buffett and Munger, is it does not encompass two major cash outflows, capital expenditure and changes in working capital: in other words the money needed to invest for future growth and to fund day-to-day operations, which are essential to the running of any business.

In the words of Buffett: ‘When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.’

This is the key consideration. If management wish to abuse the flexibility in how EBITDA is calculated, particularly if using adjusted EBITDA, it creates scope to present performance in a misleadingly positive light.

With these drawbacks in mind, why would an investor look at EBITDA? First of all, because it is calculated before interest and tax payments, it can be used to compare companies in the same sector which have different financial structures and tax domiciles.

WHAT ABOUT EV/EBITDA?

The EV/EBITDA ratio is a comparison of enterprise value with EBITDA. The enterprise value measures the total cost of buying a business. It is calculated by adding a company’s liabilities (borrowings and pensions) to the market cap and subtracting any cash. This explains why financially-distressed companies are sometimes acquired for a nominal sum of say £1, as the acquirer has to absorb all the associated debt.

As an investor it is important to look at your shares not as flashing prices on a computer screen but as part-ownership of a business. In order to know the true market value of a business you must use the EV.

An advantage the EV/EBITDA multiple has over the price to earnings multiple is that it can be used to directly compare companies with different levels of debt or cash. Also, for example, if a company issues shares to pay off its debt. This would lead to a reduction in EPS – more shares mean the earnings attributable to each individual share drops - and would lead the PE to increase in turn making the stock look superficially more expensive. However, the EV/EBITDA would be unchanged despite the new capital structure.

Ultimately, EBITDA is a useful part of the toolkit when analysing companies and can be instructive as long as it isn’t used in isolation. A useful check would be to see how much difference there is between the cash flow figure and EBITDA: if they are miles apart then serious questions would have to be asked of how transparent management are being about performance.

Calculating EBITDA

Widget maker Company X generates £1 billion in annual revenue from which £400 million of production costs are subtracted along with another £200 million in overheads like energy bills and paying staff. Depreciation and amortisation expenses total £100 million, which adds up to an operating profit of £300 million. The company pays out £50 million in interest on its borrowings, leaving pre-tax profit of £250 million. With a 20% tax rate, post-tax profit equals £200 million after £50 million in taxes are factored in. With depreciation, amortization, interest and taxes are added back to net income, EBITDA equals £400 million.

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