Going Beyond Charlie on EBITDA, Adjustments and Equity Valuation

Any article on EBITDA and applicable adjustments should probably start and end with Charlie Munger’s wise and succinct summary that EBITDA refers to “bulls**t earnings.”   As the Berkshire Hathaway annual meeting Q & A will be shortened this year, we will have less time to hear more words of wisdom from Mr. Munger.  Therefore I offer this overview of the limitations behind using EBITDA for performance evaluation, in anticipation of companies pushing overly optimistic views of 2020 performance and, hopefully, in anticipation of exuberance returning to equity markets (eventually).  I am advocating for additional scrutiny before accepting ”profitability” assertions anchored by an adjusted EBITDA methodology.

I do not know which company(ies) Mr. Munger was thinking about when he called BS.  One example could be Uber, which on Feb. 6, 2020, moved its adjusted EBITDA “profitability” target up to the end of 2020, which caused the stock to pop 9%.  [pre-virus forecast of course]  Obviously it is reasonable for a stock to rise due to good news or directional improvement.  What I am saying here is don’t lose sight of the actual profitability and cash flow of any company before bidding up the stock.   

EBITDA is often described as a short-hand proxy for “cash-flow” earnings, however this may be misleading. In my former role as V.P. & Treasurer of a Fortune 500 company I was extremely focused on real, actual cash flow.  EBITDA does not equate to liquidity or the ability to repay debt.  Payroll cannot be funded from “adjusted” cash metrics. Here is how CNBC.com on Feb. 12, 2020 reported Mr. Munger’s comments on adjusting EBITDA:

“It’s ridiculous,” Munger said, noting EBITDA — which is short for earnings before interest, taxes, depreciation and amortization — does not accurately reflect how much money a company makes, unlike traditional earnings. “Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

Corporate earnings announcements these days are reported by the media with short announcements that don’t go into great detail and often simply copy the “spin” companies provide. An accurate look at profitability needs to include Net Income, EBITDA, actual cash flow and the details behind any “adjustment” processes employed.  For example, Uber offered this detail buried in its Feb. 6th press release: 

"Adjusted EBITDA excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy"

If they concede stock-based comp is significant, recurring and important, then why adjust it away?  Clearly Uber will need to continue to pay and incentivize employees to work hard. While comp paid via share issuance does not require a cash transfer, it does involve dilution and equity costs that should not be ignored as the alternative would have to be higher cash pay instead. 

Other concerns with EBITDA as a proxy for cash-flow or profitability include:

• Viewing depreciation and amortization solely as an add-back is misleading. Most companies need to buy or lease capital equipment on a regular basis to continue existing operations, and fund maintenance and repairs to prolong asset life.  A true measure of forecast cash flow (or profitability) should reduce the D & A add-back by an estimated amount of spending on maintenance/replacement/reinvestment.  In other words, EBITDA is more appropriate where Cap Ex assets on the books have longer lives and EBITDA – Cap Ex is likely a better debt coverage metric. Note – be aware there may be a difference in the level of conservativism applied to depreciation schedules between companies.
• The cash flow impact of working capital is missing from EBITDA.  Working capital may be generating cash or utilizing cash, depending in part upon the growth profile.
• EBITDA may be manipulated by timing certain P & L recognition events, adjustments or write-downs.  EBITDA does not reveal whether accounting policies are conservative or aggressive, or whether earnings quality is strong or weak.
• EBITDA does not show whether companies are closer to the top or bottom of their cycle.  It is not forward-looking. It will not reveal, for example, whether ride sharing companies in the future may be faced with the additional expense of unemployment insurance (which most companies pay), if their drivers will now be eligible to receive such benefits. 
• Accounting conventions in various countries may impact the value of using EBITDA to make effective comparisons across borders.
• EBITDA does not reveal where the cash flow is being generated and whether it is in a foreign or restricted subsidiary and available for (tax-free) repatriation or debt repayments.
• EBITDA does not reveal unique characteristics between companies, balance sheet differences, asset strength, earnings consistency, contingent liabilities, etc. Bottom line: EBITDA should never be considered in isolation.

I’m not saying EBITDA metrics are worthless; I use them myself when looking for a quick valuation estimate, within reason. I also concede GAAP metrics have limitations as well.  Rather, I am advocating for greater scrutiny around those pushing EBITDA due to the potential for inaccurate conclusions.  There is value in using EBITDA multiples for comparison purposes, especially when there is a reasoned and thoughtful process to eliminate one-time charges and normalize run-rates.  I support add-backs of excessive business expenses related to “optional” items often found in family businesses, such as above-market salaries, company boats, sports cars, hunting lodges, etc.   [Beware the banker who favors only adjustments which generate higher valuations, especially when the banker is incentivized to profit from a sale . . .]  Excluding interest expense may help better compare equity vs. debt financed companies, etc.

I hope the thoughts above will help you put EBITDA and non-GAAP metrics in the proper context and avoid misleading analysis or optimistic spin.