Should investors use EBITDA - or is it a folly?

“I think that, every time you see the word EBITDA, you should substitute the word 'bulls**t earnings'." -- Charlie Munger

The earnings before interest, taxes, depreciation, and amortization, or EBITDA metric has its uses, and has become an extremely popular standard to measure business performance. However, the figure is highly misleading, it's easy to manipulate and should be taken with a pinch of salt. (The same can be said for almost all financial figures and metrics, but few are as easily and frequently manipulated as EBITDA.)

Warren Buffett and other famous investors have spoken out about their dislike of the EBITDA standard. Buffett in particular wrote about the financial metric within his 2000 and 2002 annual reports to Berkshire Hathaway shareholders:

“...References to EBITDA make us shudder...We're very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.

"Trumpeting EBITDA...implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business..."

Out of thin air

A famous case study, which highlights how extremely misleading EBITDA figures can be, is Vivendi Universal. Vivendi, a French telecoms group, is still around, although today it is a shadow of its former self.

Due to high levels of depreciation and razor thin margins, the use of EBITDA as a substitute, or proxy for cash flow, as well as a measure of business growth is extremely common within the telecoms sector.

Just after the dot-com bubble burst, for the three years ending June 30, 2002, Vivendi reported EBITDA profits of $7.9 billion, a sizable sum. Enter Edgar Bronfman Jr., who after selling his family entertainment company to Vivendi during 2000, became vice chairman of the cable company. Edgar Bronfman, commissioned Goldman Sachs to investigate Vivendi's accounts. They found that over the three year period, after excluding EBITDA adjustments, the company had lost, not earned, $6.5 billion. Vivendi's creative accountants had managed to pull $14.4 billion out of thin air.

Changing sides

EBITDA is often used as a proxy for operating cash flow, and while the two figures have their similarities they are completely different. The astute investor will look past the EBITDA figures to the actual cash flow numbers, a comparison of the two can yield invaluable information about the company's accounting practices.

And when you switch sides, from a buyer of stock, to a seller, (sell side in other words) you start to understand why the EBITDA figure can be so unreliable.

Normalizing EBITDA, the process of removing non-recurring expenses or revenue from a financial metric, or adjusting the figure to present the most optimistic value possible, is commonplace within the private equity industry. But it's also an extremely common practice for companies.

The five points below were taken from an article entitled, “The Top 10 EBITDA Adjustments to Make Before Selling a Business". The article's focus is to help business owners achieve the best price for their company when selling, and shows how easy to manipulate EBITDA really is.

5 EBITDA Adjustments to Make Before Selling a Business

1. Non-Arms-Length Revenue or Expenses, Below Market Value Transactions. Companies will often enter into transactions with related parties at a price that is lower or higher than market rates. When producing the annual accounts, these figures should be normalized (increased) to reflect market rates.
2. Salaries and Bonuses, as well as stock options issued during the year will be added back in, once again boosting EBITDA.
3. Start-Up Costs added back in to boost EBITDA. As start up costs are usually one-offs this becomes part of the 'normalization' process.
4. One-off lawsuits, Arbitrations, Insurance Claim Recoveries, Disputes and Professional Fees, once again these one-off costs or payouts are added/deduced as part of the normalization process.
5. Everything else, a whole selection of expenses that cannot be categorized anywhere else on the balance sheet may be added back in. Effectively, this makes EBITDA a dumping ground.

Hang on a minute

Before you totally disregard the use of EBITDA as an accounting and valuation metric, there is some data that suggests that EBITDA, when combined with the total enterprise value, or TEV metric, could be one of the most reliable figures for uncovering value investments.

Total Enterprise Value (TEV) is defined as: TEV = Market Capitalization + Debt + Preferred Stock Value - Cash and Short-term Investments.

A paper published during 2012, entitled Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years, set out to look at the performance of several quant style valuation metrics over four decades. The valuation metrics were:

1. Earnings to Market Capitalization (E/M).
2. EBITDA to Total Enterprise Value (EBITDA/TEV).
3. Free Cash Flow to Total Enterprise Value (FCF/TEV).
4. Gross-Profits to Total Enterprise Value (GP/TEV).
5. Book Value of Equity to Market Capitalization (B/M)

Of these five metrics, the evidence suggests that EBITDA/TEV has historically been the best performing valuation metric based on a variety of analyses. This data is backed up with support from the Quantitative Value book, written by Gray and Carlisle.

The data within Quantitative Value shows that out of several valuation metrics, including free cash flow yield, book value to market and earnings yield, the portfolios run by EBIT/TEV and EBITDA/TEV valuation metrics perform the best. EBIT/TEV generated a CAGR of 14.55% from 1964 to 2011, while the EBITDA/TEV portfolio achieved a CAGR of 13.72%.

Conclusion

EBITDA can be a highly misleading figure but when combined with TEV and used as a valuation metric it can boost returns over the long-term. Whether or not you choose to rely on the figure really depends upon your investing style.

For example, a large portfolio of 30 or more stocks, all of which trade at low EBITDA/TEV ratios and subject to regular rebalancing, is likely to outperform over the long-term. However, EBITDA can be a misleading if you're trying to pick companies from the bottom up, without a broadly diversified quant style portfolio.

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