Is EBITDA really "bullshit earnings"?

Charlie Munger is well known for his critical view on EBITDA, a metric favored by bankers and Wall Street experts. Why is that?

Key Takeaways

  1. EBITDA's Purpose: Simplifies operational earnings review, excluding financial nuances.

  2. Munger's Criticism: Highlights EBITDA's misleading nature by ignoring key expenses.

  3. EBITDA's Gaps: Fails to account for taxes, interest, and depreciation costs.

  4. Misuse Examples: Cites WorldCom as EBITDA manipulation, risking investor misjudgment.

  5. Popularity vs. Depth: Remains widely used for simplicity, but deeper analysis is advised for comprehensive insight.

Understanding EBITDA

Let's talk about EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Imagine it as a way to look at how much money a business makes just from doing its main job, without getting distracted by other money matters like paying loans or taxes. It's a tool many businesses, news folks, and banks like to use because it's straightforward and helps compare different companies easily.

Munger's Perspective

Charlie Munger, a really smart investor, wasn’t a fan of EBITDA. He called it "bullshit earnings" because he thinks it doesn't show the full picture of how a business is doing. According to him, ignoring things like how much a company pays in interest or taxes can make a business look healthier than it really is.

Potential

Even though Munger had his doubts, EBITDA can still be useful. It gives us a simple way to see how good a company is at making money from its main activities, without worrying about the costs from loans or the effects of taxes for a moment. But remember, it's just part of the story, and there's a lot more to consider when looking at how well a business is really doing.

Charlie Munger has sadly passed away in 2023

EBITDA's Flaws

When we talk about EBITDA, we're skipping a big part of the story: taxes. Taxes can take a big chunk out of a company's earnings, and how much they pay can vary a lot based on where they operate and how they're set up. For example, two companies might look the same through the EBITDA lens, but one might be paying a lot more in taxes because it's in a high-tax country. This means we're not getting the full picture of what a company gets to keep at the end of the day.

The Problem with Overlooking Interest

Another thing EBITDA doesn't worry about is interest expenses. These are the costs a company faces for borrowing money. For companies with a lot of debt, interest can be a huge expense, eating into their profits. By not considering interest, EBITDA can make a company with lots of debt look more profitable than it really is, which isn't giving us the true health of the company's finances.

Depreciation and Amortization

Lastly, let's talk about the 'DA' in EBITDA: Depreciation and Amortization. These are costs that account for the wear and tear on a company's assets or the loss of value of intangible assets over time. Even though no actual cash is being spent day-to-day, these expenses reflect the cost of doing business and investing in the future. Ignoring them makes EBITDA a less reliable measure of how sustainable a company's earnings are, because it overlooks the ongoing investment needed to keep the company running smoothly.

EBITDA and Misrepresentation

Using EBITDA can sometimes make businesses look more valuable than they really are. A famous example is WorldCom. This company managed its numbers to make its financial health appear much better by playing around with EBITDA. This kind of manipulation can fool investors into thinking a company is doing great when it's not, leading to wrong investment decisions.

Extending the Flawed Logic

Imagine if we took EBITDA a step further and created something like EBITDAM, where we also ignore marketing expenses. This idea shows how ignoring real costs can get out of hand. Just like we can't ignore the wear and tear on equipment or the interest on loans, we can't overlook the money spent on marketing. It's a real cost that affects a company's profitability.

The Persistent Use of EBITDA

Despite these issues, EBITDA remains popular. It's a simple way to compare companies without getting bogged down in the details of their different financial situations. This simplicity can be really helpful, especially when you're trying to get a quick idea of a company's operational success. But it's important to remember that it's just one piece of the puzzle, not the whole.

Conclusion

As we wrap up our journey through the complexities of EBITDA, it's clear that while it offers a simplified glance at a company's operational earnings, it's not the be-all and end-all. By overlooking taxes, interest, depreciation, and amortization, EBITDA can paint an incomplete picture of a company's financial health. Remember, a deeper dive into the full financial landscape is crucial for making informed decisions. If you've found this exploration helpful or have more questions, don't hesitate to reach out or check our referral program for more insights. Your understanding and financial success are what drive us to share these insights.

Happy investing!
Josh

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