EBITDA is a common profitability metric also used as a proxy for cash flow in advanced S&OP/ IBP processes. Warren Buffet has condemned the use of EBITDA and stated that “companies like Wal-mart, GE, and Microsoft—they’ll never use EBITDA in their annual report.”
This article covers the following:
- What’s EBITDA?
- Why Warren Buffet disgusts EBITDA?
- What are the alternatives to EBITDA?
What’s EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The reasoning behind EBITDA is showing the business operational performance without considering the financial aspects.
Annual taxes depend on the government and may not be linked to operational performance. Likewise, interest cost depends on the debt that the company bears and on the capital structure.
Some companies may favor third-party financing while others shareholder’s equity. By excluding depreciation and amortization that are “non-cash items”, EBITDA focuses on the cash profits of a company.
Precisely, EBITDA has its origins in being able to compare operational performance among companies. Liberty Media Chairman John Malone developed this metric in assessing leveraged buyouts.
The firm found EBITDA helpful to evaluate operational performance because taxes and capital structure are likely to change in a buyout anyway.
Since the 1980’s, the use of EBITDA has been widely spreading as a metric of corporate profitability and as a proxy for cash.
Although EBITDA is not recognized by GAAP (Generally Accepted Accounting Principles), some public companies even report EBITDA in their quarterly results.
Why Warren Buffet hates EBITDA?
EBITDA’s popularity comes with criticism. During the dotcome bubble, some companies abused it to show greater financial performance by overstating earnings.
More recently, EBITDA gained bad reputation when WeWork—a shared office space service provider—filed a prospectus for its initial public offering (IPO) excluding general, administrative and sales and marketing expenses, reporting “Community Adjusted EBITDA”.
Charlie Munger referred to EBITDA as bullsh*t earnings and Warren Buffet accompanies this sentiment. As EBITDA’s use is two-folded—profitability metric and proxy for cash—we will cover its flaws on both aspects.
On the profitability’s side, EBITDA overstates earnings in capital-intensive industries. As depreciation and amortization are added back, profits are greater.
However, in Warren Buffet’s words, “does management think that the tooth fairy pays for capital expenditure?” EBITDA can also lead to different results depending on the Accounting rules.
For example, 100% of R&D expenses go to the P&L per GAAP. However, under the International Financial Reporting Standards (IFRS), companies must also expense research expending but, development costs may be capitalized—asset on the balance sheet—if the asset will become commercially viable.
Adding to this shortcoming, the non-cash items included in the EBITDA calculation may vary in different reporting periods by creating inconsistency in the measurement system.
These limitations also have negative effects when companies use EBITDA as a proxy for cash flow.
What are the alternatives to EBITDA as proxy for Cash Flow?
Let’s start with EBITDA as proxy to cash flow and the baseline for comparison. We then go over the alternatives to EBITDA.
EBITDA
EBITDA calculation is simple to perform. The source is the Profit and Loss Statement (P&L) or Income Statement. It takes net income that is the bottom line of the P&L and adds back Interest, Taxes, Depreciation, and Amortization.
All these concepts are also included in the P&L when following accrual Accounting. By adding these concepts back, we are removing the effects of financial aspects—interest and taxes—and of non-cash items.
Depreciation and amortization are non-cash items. Depreciation is a reduction in the value of an asset like Property, Plant, and Equipment (PPE), due to wear and tear.
Amortization is the same as depreciation but applied to intangible assets. Considering this, EBITDA works well for mature businesses or with no or minimal capital expenditures (CapEx).
Key points about EBITDA
- Simple calculation
- Good fit for a mature business or with no or minimal CapEx
- Not a true cash flow measure
- Does not consider CapEx
- Does not include changes in working capital
Cash Flow from Operations – CF or CFO
Cash flow from operations is the cash generated and used in the business’ regular activities. Supply Chain has a massive impact on the Cash Flow from Operations through Inventory Management.
Precisely, there is a specific inventory line in this section of the Cash Flow Statement. Cash Flow from Operations has various improvements over EBITDA.
It considers all non-cash items, including inventory write-offs and unrealized gains or losses. Cash flow from operations also considers interest and taxes and the changes in working capital such as changes in inventory, accounts receivable, and accounts payable. Still, this alternative to EBITDA disregards CapEx.
Key points about CF
- Considers interest and taxes
- Adds back all non-cash items
- Adjusts for changes in working capital
- Does not consider CapEx
Free Cash Flow – FCF
This is the cash flow available after considering CapEx. This is a significant improvement in comparison to EBITDA and to Cash Flow from Operations.
It builds on the improvements of Cash Flow from Operations by adding CapEx. Capital Expenditures are reinvestments back in the business, necessary to maintain it or for growth.
The Free Cash Flow calculation is off the Cash Flow Statement and it is as follows:
Key points about FCF
- Considers interest and taxes
- Adds back all non-cash items
- Adjusts for changes in working capital
- Does consider CapEx
Free Cash Flow to Equity – FCFE
Free Cash Flow to Equity is also known as levered free cash flow. This is the cash flow available to equity investors after paying interest to third-party creditors, considering net debt issue and capital reinvestments in the business.
In a nutshell, Free Cash Flow to Equity adds net debt issue to the Free Cash Flow calculation. The Free Cash Flow to Equity formula is as follows:
Key points about FCFE
- Considers interest and taxes
- Adds back all non-cash items
- Adjusts for changes in working capital
- Does consider CapEx
- Does consider Net Debt Issue
Free Cash Flow to the Firm – FCFF
Free Cash Flow to the Firm is also known as unlevered free cash flow. It is the cash flow that a company generates under the assumption that is 100% financed with equity.
It is a hypothetical scenario to estimate the business valuation if there were no debt. In this way, we are removing the financial aspects.
We can use the Free Cash Flow to the Firm in the Discounted Cash Flow Analysis to get to the Total Firm Value. The calculation of the Free Cash Flow to the Firm is below:
As we can see, the calculation starts with EBIT (Earnings Before Interest and Tax) from the P&L. As a second step, we want to calculate the hypothetical tax that the company would pay when there is no debt.
Next steps are adding back the depreciation and amortization to completing the calculations by deducting any non-cash working capital increase and CapEx that we can take from the Cash Flow Statement.
Key points about FCFF
- Assumes that the firm is fully financed with equity
- Calculates the hypothetical tax in this debt-free scenario
- Can be used to calculate the Total Firm Value
Conclusion
EBITDA as a proxy for cash flow is not appropriate for capital-intense companies, as this metric does not consider capital expenditures (CapEx), among other factors. Alternatives to EBITDA are as follows:
- Cash Flow from Operations
- Free Cash Flow
- Free Cash Flow to Equity
- Free Cash Flow to the Firm
Cash Flow from Operations presents several improvements over EBITDA including changes in working capital but, still, does not consider CapEx.
Free Cash Flow addresses this flaw, adding CapEx to the calculation. Free Cash Flow to Equity includes the impact of interest expense and net debt issuance (repayments) while Free Cash Flow to the Firm excludes them.
