We may know what EBITDA means, but what it stand for?
“Bullshit earnings” — that’s how the late Charlie Munger, Warren Buffett’s right-hand man at Berkshire Hathaway, famously described EBITDA. While this frank assessment might seem harsh, it captures a sceptical, maybe cynical, view of many seasoned investors toward a metric that has become ubiquitous in corporate boardrooms and financial analyses worldwide.
EBITDA, officially standing for Earnings Before Interest, Taxes, Depreciation, and Amortisation, has spawned countless alternative interpretations that reveal the metric’s contentious nature. From “Earnings Before I Trick the Dumb Auditor” to” “Everyone’s Best Imaginary Tale of Pounds Available” these playful reworkings highlight legitimate concerns about a measure that strips away so many real business costs that critics argue it can make almost any company appear profitable on paper.
The Origins: Everything Before It Tried Deceiving Anyone
EBITDA wasn’t developed as a broad profitability comparison tool across industries, but was invented by billionaire investor John Malone in the 1970s as he consolidated cable television systems. Malone’s genius wasn’t just in building scale—it was in getting Wall Street to focus on a metric that suited his tax-minimisation strategy perfectly.
It provides a better view of actual business health and how well its business model is working by removing capital investment and financing variables
To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimise reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow. By introducing EBITDA, Malone created a vocabulary that would eventually dominate corporate finance, though perhaps not always for the right reasons.
EBITDA’s popularity stems from several seemingly logical advantages. It provides a better view of actual business health and how well its business model is working by removing capital investment and financing variables. For analysts and investors, EBITDA offers a standardised way to compare companies across different industries, tax jurisdictions, and capital structures.
Practical Purposes: Earnings Become Interesting Topics Despite Anomalies
Operational Focus: EBITDA allows for a clear assessment of a company’s operational performance by excluding non-operational factors like interest, taxes, and depreciation. This can provide insight into how well management is running the core business operations.
Comparative Analysis: It enables analysis and comparison of profitability among companies and industries, eliminating the impacts of financing, government, and other accounting decisions to provide a raw indication of earnings.
Cash Flow Proxy: EBITDA is often used as a proxy for cash flow because it excludes non-cash expenses such as depreciation and amortisation, making it useful for evaluating debt service capacity.
M&A Applications: EBITDA is often preferred over other metrics when deciding which business is more attractive in a mergers and acquisition strategy, as it provides a cleaner view of operational performance.
On the other hand… Every Body In Time Doubts Accounts
However, EBITDA’s apparent strengths mask fundamental weaknesses that have drawn fierce criticism from respected investors and analysts. Any metric that can be described as ‘profits before costs’, as is the case with EBITDA, can be regarded suspiciously.
The Depreciation Delusion: Depreciation is not something that can be breezily disregarded as not really that important. It is a device that spreads the cost of historical investment by the company’s management over the expected life of tangible assets. Warren Buffett’s pointed question remains unanswered: does management think the tooth fairy pays for capital expenditure? Depreciation can also be an imagined figure: you only know what something is really worth if it is sold. Until that point, everything is an estimate. Right now, I say my car is worth £30,000. But can I prove it?
Even more delusion: Amortisation. Usually defined as depreciation of intangible assets, amortisation could be even more shaky than depreciation. The value of intangibles is more difficult to establish than for tangible, and have you seen how creative CFOs can be when it comes to the creation of goodwill? This becomes more significant when we remember that intangible assets are not far larger on corporate balance sheets than tangibles, and have been for the last 30 years or so.
Not Actually Cash Flow: EBITDA is often treated as a proxy for cashflow. A better description may be a proxy – and a rough one – for cash generation. Show me a company with a meaningful depreciation and amortisation charge that is spending nothing on capital expenditure, and I will show you a business that will fail over time. The metric ignores the reality that most businesses must continually reinvest in their assets to maintain operations.
Misleading for Capital-Intensive Industries: Capital-intensive industries love EBITDA. A company with a 5% operating margin and a depreciation and amortisation charge of 10% of sales will produce an EBITDA figure three times higher than its EBIT. This creates a dangerously flattering picture for businesses that require heavy ongoing investment.
Hidden Working Capital Issues: EBITDA does not account for changes in working capital, and liquidity fluctuates because of interest, taxes and capital expenditures. Companies can appear healthy on an EBITDA basis while facing serious cash flow constraints.
Beyond theoretical concerns, EBITDA creates real-world problems in business decision-making. While designed for external reporting, EBITDA is frequently used in internal management reports, but without explanation as to why.
The metric’s limitations become particularly dangerous in highly leveraged situations. Interest in the EBITDA figure could make the company look as though it has more money to pay interest. The reality might be very different. This has led to overleveraging situations where companies appeared capable of servicing debt based on EBITDA multiples but have struggled – especially following interest rate rises.
Furthermore, when a company is not making a net profit, investors can turn to EBITDA to evaluate a company, which can mask fundamental business problems. Companies losing money at the bottom line can still report positive EBITDA, potentially misleading investors about the business’s true financial health.
Alternatives for Analysis: Equity Buys Interesting Trades in Debt Alternatives
Given EBITDA’s limitations, several alternative metrics provide more accurate pictures of business performance:
Economic Value Added (EVA): By deducting the capital charge, EVA automatically sets aside the profit that must be earned in each period to recover the value of the capital that has been invested or will be invested. Unlike EBITDA, EVA accounts for the true cost of capital and provides a direct link to shareholder value creation.
Free Cash Flow: This metric accounts for capital expenditures that EBITDA ignores, providing a more realistic view of cash generation capabilities. Free cash flow shows what’s actually available to shareholders after necessary reinvestment.
Return on Invested Capital (ROIC): ROIC measures how efficiently a company generates profits from its invested capital, providing insight into management’s ability to create value.
Operating Cash Flow: Found in the cash flow statement, this metric shows actual cash generated from operations, including working capital changes that EBITDA overlooks.
Despite its flaws, EBITDA isn’t entirely without merit in specific contexts. In industries where accounting policies create significant variations in depreciation methods; EBITDA can provide a standardised comparison point.
The metric can also be useful for:
- Initial screening of acquisition targets
- Comparing companies with vastly different capital structures
- Analysis of businesses in early stages where depreciation policies haven’t stabilised
- Evaluating operational improvements separate from financing decisions
The Bottom Line: Excuse But I Think Data’s Approximate
The next time you see a company or sector using EBITDA, just ask yourself: why?
Charlie Munger’s characterisation of EBITDA may be colourful, but it reflects a serious concern about a metric that has become widely accepted without sufficient scrutiny. While EBITDA can provide useful insights in specific contexts, investors and analysts should never rely on it as a standalone measure of business performance.
The financial world’s amusing alternative definitions – from ” Everything Before Investors Think Deeply About-it ” to “Elaborate Budget Ideas To Deceive Auditors” – capture more truth than many would like to admit. In an era where clear, honest financial reporting is more important than ever, perhaps it’s time to take these playful criticisms more seriously.
Why will it remain popular? Simply because, by excluding ITDA, it will always be a bigger number than Operating profit. And what do companies, Wall Street and the financial media love? Big Numbers.
Smart investors understand that no single metric tells the complete story. They use EBITDA, if at all, as one piece of a comprehensive analytical framework that includes cash flow analysis, balance sheet strength, and genuine profitability measures. After all, in the long run, businesses must generate real cash and real profits—not just “Earnings Before Intelligent Tax-Dodging Activities”
References:
https://www.asimplemodel.com/insights/who-invented-ebitda
https://www.investopedia.com/terms/e/ebitda.asp
https://corpgov.law.harvard.edu/2019/06/11/eva-not-ebitda-a-better-measure-of-investment-value/
