Yeah, I think you would understand any presentation using the word EBITDA. Every time you saw that word, you just substituted the phrase bullshit earnings. Why does Charlie Munger hate EBITDA? And what is EBITDA in the first place? In this video, I'll explain what EBITDA is, why it's so popular on Wall Street, and why Warren Buffett and Charlie Munger hate it so much.
Hi, my name is Brian Feroldi. I'm a financial educator who's been analyzing and investing in businesses for more than 20 years. But let's get going. So what is EBITDA?
EBITDA is simply an acronym that stands for earnings before interest, taxes, appreciation, and amortization. EBITDA is simply an alternative way to measure a company's profits. Many people use EBITDA as a rough estimate of how much cash flow a business is generating over a given period of time.
Now, EBITDA is what's known as a non-GAAP. term, meaning it doesn't comply with generally accepted accounting principles. For that reason, you won't find EBITDA listed on most companies' financial statements. However, you can easily calculate a company's EBITDA by looking at its income statement and cash flow statement.
First, let's take a look at the company's income statement, where you can simply find its EBIT, or earnings before interest in taxes. This is also known as a company's operating income. To find a company's earnings before interest in taxes, we simply take the company's net income, aka earnings, and then we add back in the interest expense and the company's tax expense. In this case, this company's earnings before interest in taxes is $5,000.
Now those terms are all easy to understand. It's the latter two terms, depreciation and amortization, that need more of an explanation. So what is depreciation?
This is simply an accounting method that spreads out the cost of a tangible asset over its useable life. Depreciation happens to tangible assets, which are simply assets that you can physically touch, such as a car, manufacturing equipment, or a building. These assets lose value over time, and depreciation is a non-cash charge that companies take to account for that loss of value. Now, as for amortization, This is a very similar concept to depreciation.
It's an accounting method that spreads out the cost of an intangible asset over its useful life. Now, an intangible asset is simply any asset that you can't physically touch, such as a loan or a copyright. or a patent. Intangible assets also lose value over time, and accountants write them off by amortizing them. So as a reminder, depreciation happens to things you can touch, amortization happens to things you can't touch.
Now, while these assets do lose value, they don't cost the company cash when they do so. That makes them non-cash charges. However...
Most companies do not break out their depreciation and amortization expenses as line items on their income statement. Instead, they simply lump them into operating expenses or a cost of goods sold. All the company's non-cash charges, such as depreciation and amortization, are called out on the company's cash flow statement. So for this company here, if we want to calculate its EBITDA, we would simply take in the company's non-cash charges, which are depreciation and amortization of $1,000, and we would add that to the company's EBIT, which was $5,000.
giving this company an EBITDA of $6,000. Now, calculating a company's EBITDA can be a bit of a pain, but thankfully there's software that makes this super easy for us. On a website like FinChat.io, if you simply enter in any company's ticker symbol, such as Apple, and scroll down, they will actually show you the company's EBITDA right on the income statement. Now, why go through all this financial work to calculate EBITDA in the first place?
Now, EBITDA was invented by this guy. John Malone, who's one of the best owner-operators of all time. John Malone became a billionaire primarily by buying and operating cable companies in the 1970s, 80s, and 90s.
Now, the thing you need to know about John Malone is that he loved using debt to buy other cable companies. He also hated paying taxes. So he aggressively used depreciation expense to minimize his tax bill.
He also had a lot of interest to pay since he was using so much debt to buy other businesses. If we think through how this impacted his income statement, it led to higher depreciation, higher interest expense. Now, this lowered the company's tax bill. However, it also had the effect of lowering the company's earnings. Now, this became a big problem because bankers at the time used the company's net income to figure out how much money they would lend to a business like John Malone's.
Now, John Malone figured out how to solve this problem by convincing those bankers to focus on the company's cash flow the business generated instead of the company's net earnings. Malone began to talk up his company's EBITDA, since it was a very easy way to roughly measure how much cash flow a company was creating. Moreover, since this number excluded depreciation, interest, and taxes, it wasn't nearly impacted by the way he was operating his business. Now, Malone was hugely successful with getting his bankers on board with EBITDA.
He was able to borrow billions of dollars to buy other cable companies, which generated massive returns for investors. In fact, he sold his business to AT&T in the late 1990s for $48 billion. billion dollars.
Now Wall Street and private equity took notice of John Mullen's success and since focusing on EBITDA instead of net income allowed them to borrow far more money, it grew and grew in popularity over time. Now EBITDA also has another benefit. Since it ignores interest expense, it allows companies with different capital structures to be compared to each other.
For example, pretend we had two businesses that were functioning... no interest expense, while business B would have some interest that it had to pay on servicing its debt. So while these two businesses were functionally identical, business A would have higher net income than business B simply because business A did not have any interest expense. This is an example why using EBITDA can actually be helpful. By focusing on the company's EBITDA, we remove the effect that interest expense has on their income statements and can make an apples to apples comparison.
So if EBITDA is so great, why do people like Charlie Munger and Warren Buffett Well, there are three big reasons. Reason number one gets to depreciation. The D in this acronym really ticks Warren Buffett and Charlie Munger off. Now, Warren Buffett said that depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front before the asset has delivered any value to the business.
So it is complete nonsense to pretend that it is not an expense. Now, Buffett has a nice little parable to explain this. Imagine if a company played all of its employees' salaries for the next 10 years up front. In years 2 through 10, the company's compensation expense would be non-cash. And he says, would anyone argue that those expenses are just a bookkeeping formality?
Well, with that same logic, pretending that depreciation expense would be just as silly as this example. Problem number two that they have with EBITDA is that all of the other costs that EBITDA ignores. EBITDA excludes lots of other actual business costs, such as income taxes, interest payments, stock-based compensation, restructuring expenses, and amortization.
Now, depending on the business, these actual expenses might be hugely important to calculating the company's profit. So it's simply a huge mistake to ignore them as not real expenses. But the third reason that Munger and Buffett hate EBITDA so much is because of manipulation. If you're a skilled CFO, it's far easier for them to manipulate EBITDA to, say, whatever number that they want. It's actually harder for them to manipulate other measures of profits, such as earnings and cash flow.
Now, Buffett warns that companies that heavily promote the use of EBITDA may be trying to obscure or manipulate their results, which could indicate potential issues with transparency and the trustworthiness of management teams. This is why Buffett and Munger prefer to use other firms. financial metrics to judge a company's earnings power, such as gross margin, return on equities, and owner earnings. Now, if you're interested in getting more details on the numbers that Warren Buffett focuses on when he's annualizing a business, just visit the website longtermmindset.co slash Buffett or click the link you see on your screen, and I will email you a free copy of a PDF that has all of Buffett's financial statement rules of thumb.
Well, I hope this video was useful. If so, give it the thumbs up and let me know in the comment section below what other financial videos you'd like me to make. Now, if you enjoyed this video, there's a 100% chance you'll enjoy this other video I made next.