EBITDA: WARTS AND ALL

Anthony H. Catanach Jr. and J. Edward Ketz

Grumpy Old Accountants, March 2012

With the earnings season upon us, discussions in recent weeks sometimes
have focused on pro forma numbers, especially with respect to several IPOs.
Some pro forma numbers are better than others. Most, however, are
inferior to GAAP (generally accepted accounting principles) numbers.

What these pro forma constructs have in common is that they are non-GAAP
numbers, which means that their definition and measurement are not
standardized by any agency, and more importantly that corporate
disclosures about them are not audited. By itself, this does not disqualify
them from use, but should alert the user to apply caution.

One particularly good pro forma number is free cash flow. The variable is
supported by economic theory, and its components (cash generated by
operating activities and capital expenditures) are found in GAAP financial
statements, which means they are audited numbers.

However, many pro forma numbers are bad. Take for example Groupons
consolidated segment operating income. The number is not supported by
any theory, and is simply a figment of Groupons imagination. It is not
audited, and is therefore of low quality, and it dismisses items such as
marketing and merger costs as if these expenses are not real. Worst of all,
Groupon is the only firm that employs this metric, which destroys any
chance of comparing Groupons metric with values from other entities. The
real purpose of such pro-forma disclosures is to divert the readers attention
away from the red ink on the income statement, not improved investor
decision-making.

But today we shall focus on EBITDA: earnings before interest, taxes,

depreciation, and amortization. This metric has both some advantages and
some disadvantages. Overall, we think the disadvantages are weightier, but
we shall let our readers judge for themselves. By the way, others who have
weighed in on the issue are Richard Wayman at Business Evaluation
Systems, Sharon McDonnell, Wade Slome at Seeking Alpha, and the Motley
Fool.

We dont know when EBITDA was invented, but we do know that its
popularity soared during the late 1980s and the 1990s, as investment
bankers tried to justify merger and acquisition deals for target firms with
operating losses. EBITDA use peaked during the dot com craze of the late
1990s, when analysts, bankers, traders, and even some investors sought to
justify lofty prices for internet business models. Unfortunately, the dot com
busts near the end of the 20th century unmasked the limitations of EBITDA.

Okay, so what are the advantages of EBITDA? First, the construct is well
defined inasmuch as the number equals operating income plus interest
expense, depreciation, depletion, and amortization charges. Nothing like
having a measure upon which we all can agree how it is measured!

A second advantage of EBITDA is that its components are GAAP-based, and

thus are audited numbers. As an outsider, it is always preferable to have an
auditors stamp of approval because you never know when management
consists of a bunch of schemers. Besides, it is nice to have deep pockets to
sue if these numbers turn out bogus. So much for the advantages.

What are the disadvantages of EBITDA? First and foremost is that nobody
knows what EBITDA is really measuring. EBITDA clearly is not earnings, as
it pretends that some very real costs are fictional. It tries to undo the hard
work of the accounting profession in obtaining decent estimates on
profitability. As Warren Buffet said in the Presidents letter in the 2002
annual report of Berkshire Hathaway:

Trumpeting EBITDA (earnings before interest, taxes, depreciation and

amortization) is a particularly pernicious practice. Doing so implies that
depreciation is not truly an expense, given that it is a non-cash
charge. Thats nonsense. In truth, depreciation is a particularly
unattractive expense because the cash outlay it represents is paid up
front, before the asset acquired has delivered any benefits to the
business. Imagine, if you will, that at the beginning of this year a
company paid all of its employees for the next ten years of their
service (in the way they would lay out cash for a fixed asset to be
useful for ten years). In the following nine years, compensation would
be a non-cash expense a reduction of a prepaid compensation
asset established this year. Would anyone care to argue that the
recording of the expense in years two through ten would be simply a
bookkeeping formality?

Nor is EBITDA a cash flow. It does not proxy for cash flow because it
ignores working capital changes, adjustments for changes in deferred
income taxes, as well as the effects of other long-term adjustments. In no
way is it a proxy for cash flow. Besides, if somebody were interested in cash
flow, why wouldnt they just look at the cash flow statement? Thus, EBITDA
is neither earnings nor cash flow. Indeed, we have no idea what it really is
measuring.

Finally, EBITDA is not value relevant. There is no economic theory that links
EBITDA to the value of the firm. Yes, there are some models that claim to
do this, but they adjust EBITDA for the missing items we note above, and in
effect convert the measure either to operating income or to free cash flow.
They still do not map EBITDA directly into value.

Overall, we urge financial statement users to be careful when using non-

GAAP metrics. Make sure you know what you are measuring, and be sure
your metric is reliable. Otherwise, you are defrauding yourself, intellectually
for sure, and possibly financially.

This essay reflects the opinion of the authors and not necessarily the
opinions of The Pennsylvania State University, The American College, or
Villanova University.