Why Warren Buffett dislikes the EBITDA metric
Written byCFI Team
Why does WarrenBuffett dislike EBITDA?
Warren Buffett is well known for disliking EBITDA multiples to value a business’s financial performance. But why?
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” It is one of many indicators of a company’s financial performance; however, it excludes depreciation and amortization on the basis that they are “non-cash items.” Depreciation and amortization are also a measure of what the company is spending or needs to spend on capital expenditure to maintain or grow the business. So although EBITDA is used as a measurement of a company’s earning potential, it does not account for the cost of debt capital or its tax effects.
A company that spends zero money on capital expenditures could be well suited to use EBITDA metrics as the non-cash depreciation and amortization part does not have to be replaced with CapEx – but this applies to almost no businesses. Companies who have large amounts of fixed assets subject to heavy depreciation charges, or who have acquired intangible assets on their books and are thus subject to large amortization charges use this EBITDA when measuring their earnings. Creditors also often use this measurement.
Warren Buffett shares some of his thoughts on EBITDA:
“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.”
“We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report.”
“The tooth fairy pays for capital expenditures?”
Warren Buffett is credited with having said, “Does management think the tooth fairy pays for capital expenditures?”
EBITDA is used to analyze and compare the profitability between different companies in the same industry as it eliminates financing effects and accounting decisions. Many times, a company changes the items included in their EBITDA metric calculation from one reporting period to the next. Because of this, Warren Buffett does not think that it is a true representation of the company’s performance financially.
In other words, Mr. Buffett is pointing at the fault of using EBITDA metrics inthat they exclude depreciation and amortization as a means of valuing the company. Although the depreciation and amortization expense is not an actual cash outflow, it does, in effect, reduce the value of a company’s total assets through reducing the value of specific capital and/or financial assets. This reduction in value is intended to closely mimic the true nature and value of the asset.
As an example, imagine a company that has no other assets other than multiple factories under its Property, Plant, and Equipment asset account. Naturally, over time, these factories would lose value as they age and are used up. Using EBITDA as a means of valuing this company would be entirely fallacious, as it would not account for the loss in value that the factories are experiencing. Using EBITDA, in this case, would overstate the company’s earnings, and thus, overstate their value.
Additional resources
This has been a guide to Warren Buffett on the topic of EBITDA, and the reason why it isn’t always a good valuation metric. To keep learning and progressing your skills, check out these additional resources:
As someone deeply immersed in finance and valuation methodologies, it's crucial to recognize the nuanced perspectives of renowned investors like Warren Buffett. My extensive knowledge in financial analysis and valuation principles allows me to shed light on Warren Buffett's reservations about the EBITDA metric.
EBITDA, standing for "earnings before interest, taxes, depreciation, and amortization," is a widely used financial metric for assessing a company's profitability. However, Warren Buffett, the legendary investor, expresses skepticism about its application for several reasons.
Firstly, EBITDA excludes depreciation and amortization, labeling them as "non-cash items." While this omission might seem reasonable on the surface, it overlooks the fact that depreciation and amortization reflect the actual expenses a company incurs for maintaining or expanding its operations. Buffett argues that these costs are integral to understanding a company's true financial health, as they represent the capital expenditure required to sustain its assets.
Buffett's perspective becomes particularly poignant when considering companies with significant fixed assets subject to substantial depreciation or those holding intangible assets with substantial amortization charges. In such cases, relying solely on EBITDA can distort the assessment of a company's earnings potential by disregarding the genuine costs associated with its assets.
Buffett dismisses the widespread use of EBITDA, emphasizing that it can be a tool for financial obfuscation. His remarks about not investing in companies that heavily emphasize EBITDA underscore his concern about the metric's potential association with fraudulent practices. He cites examples of reputable companies like Wal-Mart, GE, and Microsoft, which refrain from using EBITDA in their annual reports.
One of Buffett's memorable quotes underscores his skepticism: "It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it."
Buffett's criticism extends to the malleability of EBITDA calculations. Companies often modify the components included in their EBITDA metric from one reporting period to the next. This inconsistency undermines the metric's reliability as a true representation of a company's financial performance over time.
In essence, Warren Buffett contends that EBITDA, while a popular tool for industry-wide profitability comparisons, falls short as a comprehensive valuation metric. By excluding crucial elements like depreciation and amortization, EBITDA may paint an incomplete and potentially misleading picture of a company's financial health.
To further delve into valuation methodologies and enhance your financial skills, explore additional resources such as valuation infographics, startup valuation metrics, valuation multiples, and a guide on discounted cash flow (DCF) modeling. These materials will provide a holistic understanding of valuation principles beyond EBITDA.
