Exploring EBITDA: Definition and Criticism

Feb 6, 2025

Lecture Notes: Understanding EBITDA and Criticisms

Introduction

  • Presenter: Brian Feroldi, financial educator with 20+ years of experience.
  • Topic: Understanding EBITDA, its popularity, and the criticisms by Warren Buffett and Charlie Munger.

What is EBITDA?

  • Definition: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
  • Purpose: Alternative measure of a company's profits and cash flow.
  • Non-GAAP Term: Does not comply with generally accepted accounting principles.
  • Calculation:
    • On income and cash flow statements.
    • EBITDA = EBIT (Earnings Before Interest and Taxes) + Non-cash charges (Depreciation & Amortization).

Components Explained

  • Depreciation:
    • Accounting method for tangible assets (e.g., car, equipment, building).
    • Non-cash charge to account for asset value loss over time.
  • Amortization:
    • Similar method for intangible assets (e.g., patents, copyrights).
    • Spreads cost over the asset's useful life.
  • Non-cash Charges: Depreciation and amortization do not cost cash but are reflected in financial statements.

Historical Context and Popularity

  • John Malone: Pioneer in promoting EBITDA in the cable industry.
    • Used debt and depreciation to minimize taxes and maximize cash flow.
    • Influenced lenders to focus on cash flow instead of net income.
  • Wall Street Adoption:
    • Focus on EBITDA allows for high borrowing, ignoring net income intricacies.
    • Useful for comparing companies with different capital structures.

Criticisms by Buffett and Munger

  • Depreciation Issues:
    • Depreciation represents real upfront costs.
    • Buffett argues ignoring it is similar to ignoring prepaid future salaries.
  • Exclusion of Costs:
    • EBITDA ignores crucial costs like taxes, interest, stock compensation.
    • These costs can significantly affect a company's actual profit.
  • Manipulation Risks:
    • Easier for CFOs to manipulate EBITDA figures compared to other metrics.
    • Companies promoting EBITDA may obscure financial transparency.

Preferred Metrics by Buffett and Munger

  • Prefer other measures like gross margin, return on equities, and owner earnings for assessing earnings power.

Conclusion

  • Importance of using comprehensive metrics for financial analysis.
  • Reference to more Buffett rules available at longtermmindset.co/Buffett for further learning.
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