Saturday, May 9, 2009

Munger and EBITDA

Berkshire MungerCharlie Munger though a pioneer in value investing and the four filters is a fairly raw character and has a way of getting to the point in a sometimes abrupt manner. Charlie did just this when he referred to EBITDA as "bullsh*t earnings" at the Berkshire Hathaway meetings in 2003.

EBITDA = Earnings before interest taxes depreciation, and amortisation.

What is the Problem with EBITDA?

Well let me give an example:
  • Company A earns $1.2M & pays $.7M in interest, taxes, & depreciation.
  • Company B earns $1M & pays $.1M in interest, taxes, & depreciation.
Which company would you want to own? Right, that is the problem with EBITDA. EBITDA hides reality by concealing normal expenses a company will encounter, and gives a false sense of the profit potential of the business.

Valid Users of EBITDA

EBITDA exists in a world of fantasy where there are no taxes or other inclining of reality. The only way to make this measure useful then is to either change reality; or to find a way not to care about taxes and depreciation.

There are only two groups who are capable of this feat: a small group of flexible business buyers, and lenders/financiers. If an industrious individual is willing to buy the company and has the capacity to refinance the debit, and possibly move the company to a another region with a better tax plan, they may be able to unlock more of the earnings shown in EBITDA. The other group who can use EBITDA are lenders who can garner some use for this number as they can access earnings before taxes are paid out- and certainly before depreciated machines are replaced. I say "some use" as EBITDA gives no indication of what other lenders are already in finance arrangements with the company in question.

EBITDA and stock holders

Common stockholders should not ever, ever, look to EBITDA as an indication of the strength of a company. How this non-GAAP measurement crept into the normal speak of the investing world is a mystery. It is often espoused by companies who are more proud of their "potential" earnings than their actual net earnings.

Munger hates EDITDA. I cringe whenever I see EBITDA in financial statements, I hope you will too!

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