The trouble with EBITDA

“Earnings before interest, tax, depreciation and amortisation is such a mouthful”, it is little wonder it is commonly abbreviated to EBITDA.

Not only is it a mouthful, but it is also sometimes hard to swallow, at least from an investors’ perspective.

The idea behind EBITDA is it takes out a couple of “non-cash” accounting adjustments – depreciation and amortisation – to the profit figure.

EBITDA is sometimes referred to as “headline earnings” and is supposed to give a better idea of the underlying performance of a company.

Well, up to a point, Lord Copper …

Tangible Dream and Goodwill Hunting

Depreciation reflects the decline in the useful value of a fixed asset over the expected lifetime of the asset. You can think of a fixed asset as something you could stub your toe on, as opposed to an intangible asset, such as the reputation of a brand (also known as “goodwill”).

Amortisation is much the same thing but applied to intangible assets, such as software, technology and trademarks.

The theory goes that a company pays a one-time sum upfront for an asset but uses it over several years so it is therefore sensible to spread the cost over the expected lifetime of the asset, almost as if it had bought it in instalments.

That’s fine and dandy but it is useful to remember that the company has paid real cash upfront and that for many companies large capital outlays are a yearly occurrence.

Depreciation and amortisation may be non-cash items but interest and tax are very definitely items that do empty the company’s piggy bank.

Getting down to brass tax

It is difficult to quibble with the exclusion of tax from the headline earnings figure as profit before tax – the earnings figure that was widely used before the fixation with EBITDA – does exactly the same thing.

I used to think that companies had no control over what the tax figure would be and that was why it was preferable to focus on the “before tax” figure, as we tend to do in the UK, rather than the “after tax” figure as they do in the USA.

Then along came the likes of Google, Amazon, Starbucks et al and I wonder “what’s the diff?” but that’s a rant for another time.

The bonus payments and incentive schemes of management are often linked to EBITDA, and you can see why executives like this particular profit measurement.

If you are the chief executive of, say, a travel company, pubs group or pizza chain that has a ludicrous amount of debt, it must be galling to see a large chunk of profits wiped out by interest payments.

Less galling, perhaps, if you are the chief executive who ran up that enormous debt in the first place or who failed to bite the bullet and reduce the debt before it became crippling, but galling nevertheless.

Paying interest is, however, “an inconvenient truth” and should not be ignored when analysing a profit and loss statement.

Beware of adjusted EBITDA

So, there are some good reasons for focusing on EBITDA rather than pre-tax profit but also good cause to be a bit sceptical and this can apply even more so to “adjusted EBITDA”.

This is where management cherry-picks a number of “one-off” (they hope) charges, such as restructuring costs, that put a dent in profits.

For instance, some companies, particularly those that have a history of overpaying for acquisitions, often like to exclude impairments from their headline earnings figures.

An impairment (often called a “write-down”) happens when the auditor has a quiet word with the board and says, you know that thing you paid a gazillion quid for? We reckon it is now worth about tuppence.

Think:

• HP’s acquisition of Autonomy 
• ITV’s acquisition of FriendsReunited
• News International’s acquisition of MySpace
• Chelsea’s signing of Andriy Shevchenko.

Once again, if the current chief executive was not the one who sanctioned the terrible acquisition, he or she is entitled to ask the remuneration committee to overlook a humongous write-down.

Investors may feel inclined to do likewise but equally, they may decide that a company prone to marking down the value of its acquisitions is a company that bears similarities to a club threatened by relegation that is managed by Harry Redknapp.

To be fair, many companies do play with a straight bat and if they adjusted for an item in the past, such as a downward revaluation of an asset, they will adjust for the same item in the future even if it is unflattering, as it would be to exclude, for example, an increase in the valuation of an asset.

Beware those companies, however, that shift the goalposts each year.

Pay attention to Johnny Cash when you walk the bottom line

EBITDA is fine as far as it goes as an investment metric but investors should also pay attention to things such as debt repayments, capital expenditure, working capital requirements, pension obligations and cash flow.

Cash flow adds back those non-cash items and it also factors in the cost of replacing those declining assets.

As is often remarked, many companies fail for want of cash rather than through being unprofitable.

Earnings can be manipulated to a certain extent; the old joke has it that a good accountant will sit down before going through a company’s accounts and ask the company how much money it would have liked to have made (or lost) last year.

Cash flow cannot be manipulated, except through shady practices. Some day, if I have time, I will meet you in a pastry shop and talk about dodgy companies I have known.

Assuming, however, that a chief financial officer is honest and reasonably competent, the advice is to take a gander at the cash flow statement.

If a company is growing EBITDA way faster than net cash inflow, that would be a red flag for many investors.

Story by ProactiveInvestors