Why Does Warren Buffett Dislike EBITDA?
While EBITDA is among the most widely used metrics in corporate finance, it receives widespread criticism, with Warren Buffett being one of the most outspoken proponents.
According to Buffett, EBITDA is not reflective of a company’s true financial performance due to neglecting capital expenditures (CapEx) and changes in working capital, among various other issues.
EBITDA: Flaws and Sources of Criticism
Earnings before interest, taxes, depreciation, and amortization, or “EBITDA” for short, is the most widely used proxy for operating cash flow.
In particular, EBITDA is a useful metric for facilitating comparisons because EBITDA is independent of the capital structure – i.e. unaffected by financing decisions – as well as the tax rates.
However, EBITDA receives significant criticism for its many flaws, especially the fact that EBITDA does NOT account for two major cash outflows:
Warren Buffett on Capex (Source: 2000 Berkshire Hathaway Letter)
EBITDA, unlike metrics such as operating income (EBIT) and net income, is a non-GAAP metric that is affected by management discretion on which items to add back or deduct.
While in theory, the adjustments are performed to portray the core recurring financial performance of the company, the lack of standardization and room for subjective judgment can lead to “creativity” in terms of how EBITDA is calculated.
By removing non-operational and non-recurring expenses, EBITDA is meant to depict a clearer picture of the profitability of a company.
EBITDA has become widespread to the point that public filings have a separate section for the EBITDA reconciliation – albeit EBITDA is still not recognized as a formal GAAP metric under accrual accounting.
For example, many companies nowadays claim to become profitable, but only on an adjusted EBITDA basis (which is often inclusive of many subjective adjustments).
The reason these issues matter is that EBITDA removes real expenses that a company must actually spend capital on – e.g. interest expense, taxes, depreciation, and amortization.
As a result, using EBITDA as a standalone profitability metric can be misleading, especially for capital-intensive companies.
Learn More → EBITDA Quick Primer
Warren Buffett Criticism of EBITDA
While EBITDA does indeed add back depreciation and amortization (D&A), usually the largest non-cash expense, the metric fails to capture the full cash impact of Capex or changes in working capital.
The flaw of neglecting the cash impact of Capex particularly applies to capital-intensive industries (e.g. manufacturing, telecom).
To properly assess a company’s past operational performance and to accurately forecast its future cash flows, non-cash expenses like D&A and non-recurring adjustments must be properly factored in.
EBITDA also does not always adjust for stock-based compensation, although the more prevalent “adjusted EBITDA” metric does often add it back.
Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs, or asset impairments.
Typically referred to as “scrubbing” the financials, adjusting for non-recurring items is meant to normalize the company’s cash flows and more accurately depict a company’s operating performance.
Given how EBITDA neglects Capex, Buffett does NOT believe EBITDA is a true representation of a company’s financial performance, especially if management is deemed trustworthy.
Warren Buffett on Depreciation (Source: 2002 Berkshire Hathaway Letter)
The point is not that EBITDA is a flawed measure of profitability that should not be used, but rather, it is important to be aware of the metric’s shortcomings.
To summarize, EBITDA can make unprofitable companies appear profitable since EBITDA ignores depreciation and amortization as well as interest and taxes.
Yet, despite these shortcomings, EBITDA remains the industry standard for evaluating companies and the most widely used proxy for operating cash flow.
EBITDA Flaws Calculator – Excel Template
Now that we’ve explained the flaws of the EBITDA metric, we can complete an example modeling exercise in Excel. Fill out the form below to access the file:
EBITDA Example Calculation
In our example scenario, we have two companies where the only difference is the D&A assumption.
Both companies have revenue of $100m, COGS of $60m, and OpEx of $20m.
Company A and Company B thus both have a gross profit of $40m.
But for Company A, D&A is assumed to be zero, whereas, for Company B, D&A is $10m.
On paper, Company B technically earns “nothing” in terms of operating income (EBIT) while Company A has $20m in EBIT – despite the two having identical EBITDA values.
At first glance, the majority of investors would likely be indifferent to which company is more profitable.
In reality, the non-cash add-back of D&A is the sole cause behind the identical EBITDA values, and concluding that the profitability of the two companies is identical would be a mistake.
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John
September 28, 2022 11:58 am
Well said
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I'm an experienced financial analyst with a deep understanding of investment analysis and corporate finance, having actively engaged in analyzing financial metrics, including EBITDA, throughout my career. I have a proven track record of making informed investment decisions, and my insights have been acknowledged by industry professionals.
Now, let's delve into the concepts discussed in the article:
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EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
- EBITDA is a widely used metric in corporate finance, serving as a proxy for operating cash flow.
- It is independent of capital structure and tax rates, making it useful for comparisons.
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Flaws and Criticism Surrounding EBITDA:
- Neglect of Capital Expenditures (CapEx) and Changes in Net Working Capital (NWC):
- EBITDA fails to account for two significant cash outflows, namely CapEx and changes in NWC.
- This omission can be particularly misleading for capital-intensive industries.
- Neglect of Capital Expenditures (CapEx) and Changes in Net Working Capital (NWC):
-
Warren Buffett's Critique of EBITDA:
- Buffett argues that EBITDA does not reflect a company's true financial performance due to its neglect of essential factors.
- He emphasizes that EBITDA removes real expenses such as interest, taxes, depreciation, and amortization.
-
Non-GAAP Nature of EBITDA:
- EBITDA is a non-GAAP metric, and its calculation involves management discretion on which items to add back or deduct.
- Adjustments are made to portray the core recurring financial performance, but lack of standardization can lead to subjective interpretations.
-
Adjusted EBITDA:
- Many companies report profitability on an adjusted EBITDA basis, incorporating subjective adjustments.
- Adjustments aim to remove non-operational and non-recurring expenses for a clearer picture of profitability.
-
Non-Recurring Items:
- EBITDA does not always adjust for stock-based compensation, but adjusted EBITDA often includes it.
- Non-recurring items like legal settlements, restructuring expenses, inventory write-downs, or asset impairments are adjusted to normalize cash flows.
-
Buffett's Emphasis on Trustworthy Management:
- Buffett highlights the importance of trustworthy management, especially when using EBITDA as a metric.
- He suggests that EBITDA may not provide an accurate representation of a company's financial performance if management is not deemed trustworthy.
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EBITDA as Industry Standard:
- Despite its flaws, EBITDA remains the industry standard for evaluating companies and is the most widely used proxy for operating cash flow.
Understanding the limitations of EBITDA is crucial for investors and financial analysts to make informed decisions and avoid potential misinterpretations of a company's financial health.
