EBITDA, or the delicate metric of bull**** earnings

Language and impact in finance

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Amortization involves spreading the cost of an intangible asset (e.g. patents or brand names) over its useful life. Depreciation refers to the process of expensing a tangible fixed asset(e.g. machines or buildings) over time to reflect its anticipated wear and tear. According to the Oxford Dictionary, depreciation is defined as “a decrease in value over time” and “the act of reducing the value, as stated in the company's accounts, of a particular asset over a specific period of time.”

Oxford Languages offers a philosophical perspective on the term "depreciation": “the expression of a negative view of someone or something; criticism or disapproval ('his caustic deprecation of famous colleagues'), the classification of a software feature as obsolete and best avoided, typically because it has been superseded.” This suggests a negative connotation to “depreciation”, also evident from the verb “to deprecate” (to express disapproval). High capital expenditures lead to significant depreciation, which can deter investors. Investments in capital-intensive industries with low returns have traditionally been unattractive to investors. A cynic might say, “one builds a one billion EUR steel factory and the day it starts producing it is worth perhaps only one tenth of its cost.”

 

Insights and critiques from the financial world

Indeed, many caustic remarks and memes have been made about the use of EBITDA in financial communication. Accounting purists have coined a sarcastic acronym for it: “Earnings Before I Tricked The Dumb Auditor”. It is not so much the auditor who is deceived, but rather the investor. In a famous discussion, Warren Buffett explained why he is skeptical of EBITDA, and Charlie Munger wryly added: “Every time you hear 'EBITDA,' substitute it with 'bull**** earnings.'” Charlie also cautioned investors about underestimating pension and medical liabilities and option expenses. The latter is a real salary cost, yet it is kept in a separate line in the profit and loss statement. The cost can be quite high. Berkshire’s managers also earn substantial bonuses, but these are recorded as cash expenses. Charlie continued, “Why not put all expenses in the footnotes? Just have sales and the same figure for profits and all expenses in the footnotes. It’s amazing what people with high IQs will do to rationalize their own pocketbooks.”

EBITDA contains two pitfalls: companies might abuse it for window dressing (providing a rosier picture of a company’s financials), and depreciation should be considered a "true," immediate expense, rather than a non-cash cost.

No one disputes the relevance of the "interest" and "taxes" components. Examining the outstanding debt provides insights into future maturities and interest payments. High leverage and high rates immediately signal a warning. The ratio "net debt/EBITDA" is commonly used to gauge a company’s leverage and thus its financial risk. It implies that EBITDA will be used to repay debt. However, EBITDA might give a misleading impression of a company's cash-earning capacity. For indebted companies, the interest coverage ratio (EBIT/interest expense) provides deeper insight. Taxes are fairly straightforward. An investor will quickly verify whether a company's effective tax rate (ETR) is reasonable. Nowadays, this typically means paying at least the "15%" agreed upon by the OECD countries. Then comes the DA. Ay, there’s the rub…

Is EBITDA a "financial camouflage technique", as a shrewd investor once described it? Any student of financial analysis learns to distinguish between cash and "non-cash" costs, which might suggest that "non-cash costs" are not real costs. Warren Buffett strongly disagrees: "Does management think the tooth fairy pays for capital expenditures?" In Buffett’s view, using EBITDA as a metric has cost investors a lot of money: "Depreciation is a real expense, and all the worse because you put money upfront and are not sure about its return. It’s not a non-cash expense". When assessing depreciation, the risk of obsolescence is crucial. Amortization is a different matter. Intangibles like brands or customer lists of strong companies often increase over time, rather than decline in value. Goodwill is a special case. Time and again, acquisitions prove to be one of the most challenging aspects of business life. After a few years, companies often "clean up" their balance sheets by taking substantial impairments, often as a prelude to a sale. In contrast, normal amortization is often considered "unnecessary" from a valuation perspective.

 

EBITDA and investment strategy: insights from Sir Jim Ratcliffe's Ineos success

So, should we always be suspicious of EBITDA? Not necessarily, because ultimately it remains a proxy for cash flow. Just make sure to check the returns on investment. Sir Jim Ratcliffe became a billionaire by investing in capital-intensive chemical companies. As an experienced chemical engineer, he founded his company Ineos in May 1998 through the buyout of a BP chemicals business. Since then, Ineos has acquired factories that were divested by other chemical companies. Ineos operates 182 facilities in 32 countries, employing 25,000 people. While we don’t know Sir Ratcliffe's views on EBITDA specifically, he clearly understands the importance of investments. Ineos’s 2023 annual report is explicit: “We benefit from the cost advantages of operating large-scale, well-invested, highly integrated facilities strategically located near major transportation facilities and customer locations. Since January 1, 2007, we and our predecessors have invested almost €12.5 billion in our production facilities to ensure that they operate efficiently, resulting in integrated, and state-of-the-art production units. We believe these investments allow us to operate at lower cost and higher utilization rates than most of our competitors, and enable us to maintain positive margin and cash flows even during downturns in industry cycles or customer demand. For the year ended December 31, 2023, our revenue was €14.9 billion and our EBITDA before exceptionals was €1.7 billion”.

There you have it. What is Jim’s secret? He is not afraid to make substantial investments to lower costs through scale and efficiency, enhance market power by increasing market share, and use leverage effectively (€10.3 billion of debt at the end of 2023). This strategy enables Ineos to generate profits during peak years (like 2021/22) and, more importantly, provides resilience in downturns. The proof of the pudding is in the cash earnings and, by extension, in the dividend payments.

 

Beyond EBITDA, evaluating integrity, performance, and growth potential

Although EBITDA meets a lot of resistance from seasoned investors, we should not dismiss it entirely. EBITDA provides a good initial and rough indication of a company's earnings power. Like any metric, it should be contextualized, taking into account the capital intensity and investment cycle of an industry, and more importantly, the return on capital employed.

In terms of valuation, employing a mix of methods remains the best approach to form an informed opinion of a company's true value. As Aswath Damodaran points out, many professionals are more occupied with “pricing” companies or stocks rather than truly valuing them. Observing the evolution of hundreds of price targets from sell-side analysts often reveals a strong correlation with the share price trend. In other words, analysts tend to “adapt” their valuation according to market sentiment. It is quite easy to tweak a target price or a “pseudo” valuation of a company. Whether using multiples like P/E or EV/EBITDA, or a more “sophisticated” DCF (discounting future free cash flows), understanding the underlying assumptions is crucial.

Ultimately, analyzing a company is straightforward. One should consider all aspects, especially the integrity of management, the quality of its products and services, and the markets it serves. The two crucial financial parameters are the return on capital employed and growth. Investors tend to favor capital-light businesses with high growth potential. While this is acceptable, there is always the risk of overpaying for a popular company. This risk is mitigated by a long investment horizon, as time is the friend of a wonderful company.