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Stocks: The uses and limits of EBITDA

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05/14/2018 | 01:23pm CEST

The EBITDA concept - earnings before interest, tax, depreciation and amortization - was made popular by unscrupulous bankers during the ‘junk bond bubble’ and has become a standard of financial communication for listed companies ever since.

A company’s EBITDA famously qualified as ‘bullshit earnings’ by the hilarious yet prodigious Charlie Munger - associated of Warren Buffett and vice president of Berkshire Hathaway - present a profit that’s very conveniently been adjusted for investment costs, funding and taxes.

In theory, a company’s EBITDA allows it to present its ‘gross’ operating earning power, regardless of the capital structure or the long-term investment strategy of the company. In reality, and in the majority of cases, the EBITDA rather serve the management in painting a picture of the company’s performance that’s more flattering than it actually is.  

Indeed, except for a company that’s not or little capital-intensive, completely auto-financed and that miraculously slipped through the net, a company’s EBITDA generally has little to do with the actual profit - something we notice as soon as we compare them.  

The fact that something is a so-called non-cash expense (a curious but practical accounting invention) doesn’t justify skipping the depreciation and amortization, in particular in the case of a very capital-intensive company  - like for example telecom operators or automobile manufacturers.

These kinds of companies are known to generate very little distributable profits for their shareholders over the long cycle, because the investments needed to develop their infrastructures or their production capacities consume all of the operating cash-flow - and more even - which is why they almost systematically have to get themselves into debt.

The income statements already give a very imperfect picture of the profitability, because besides the sometimes doubtful revenue recognition policies, we can’t clearly distinguish the weight of the investments in the fixed assets - which is sometimes higher than the depreciation - or in the need for working capital.

This problem is even more evident in the case of companies that are going through a phase of rapid growth or those that make multiple acquisitions. 

To make things worse, listed companies now almost always use a type of communication that favors the so-called adjusted EBITDA, this means adjusted for supposedly exceptional charges such as restructuring costs or a timely investment in the upgrade of the IT infrastructure.

Each industry has its preferences. Petrol and gas companies, for example, have gotten used to presenting the EBITDAX - earnings before interest, tax, depreciation, amortization and exploration expenditures -  in the title of their communications.

In other words, these exploration expenditures are incompressible when this kind of company wants to make the operating ground or drill site as profitable as possible, as long as it doesn’t decide to drill blindly….

Apart from (rare) exceptions, all the expenses adjusted by the EBITDA are real. Preferring the latter over more tangible ways of measuring the earning power - such as the net result or free cash-flow, depending on the circumstances - serves mostly for promotional or cosmetic purposes. 

If however we really had to find a use for it, we’d say that a company’s EBITDA can sometimes be useful to estimate that company’s capacity to cover its interests in an extreme scenario - supposing that the duty of paying debt would prevail over the investment efforts. This is why a company’s EBITDA primarily is useful for creditors who want to evaluate the capacity of the borrowers to fullfil their obligations.

The safest way to evaluate the actual profitability of a company - and thus to distrust all of the accounting manipulations - consists of calculating the evolution of the equity over the course of the previous financial years, adjusted for any dividend distributions and corporate actions (such as the issue or buyback of shares).

As usual, a critical reassessment of the accounts is thus indispensable in order to avoid the pitfalls of a communication that is too promotional.

Translated from the original article

Neelie Verlinden
© MarketScreener.com 2018
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