Warren Buffett on EBITDA

Warren Buffett Quote: Criticism of EBITDA

While EBITDA does indeed add back depreciation and amortization (D&A), usually the largest non-cash expense, the metric fails to capture the full cash impact of Capex or changes in working capital.

The flaw of neglecting the cash impact of Capex particularly applies to capital-intensive industries (e.g. manufacturing, telecom).

To properly assess a company’s past operational performance and to accurately forecast its future cash flows, non-cash expenses like D&A and non-recurring adjustments must be properly factored in.

EBITDA also does not always adjust for stock-based compensation, although the more prevalent “adjusted EBITDA” metric does often add it back.

Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs, or asset impairments.

Typically referred to as “scrubbing” the financials, adjusting for non-recurring items is meant to normalize the company’s cash flows and more accurately depict a company’s operating performance.

Given how EBITDA neglects Capex, Buffett does NOT believe EBITDA is a true representation of a company’s financial performance, especially if management is deemed trustworthy.

^{Warren Buffett on Depreciation (Source: 2002 Berkshire Hathaway Letter)}

The point is not that EBITDA is a flawed measure of profitability that should not be used, but rather, it is important to be aware of the metric’s shortcomings.

To summarize, EBITDA can make unprofitable companies appear profitable since EBITDA ignores depreciation and amortization as well as interest and taxes.

Yet, despite these shortcomings, EBITDA remains the industry standard for evaluating companies and the most widely used proxy for operating cash flow.

EBITDA Shortcomings Calculator

Now that we’ve explained the flaws of the EBITDA metric, we can complete an example modeling exercise in Excel. Fill out the form below to access the file:

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EBITDA Flaws Calculation Example

In our example scenario, we have two companies where the only difference is the D&A assumption.

Both companies have revenue of $100m, COGS of $60m, and OpEx of $20m.

Company A and Company B thus both have a gross profit of $40m.

But for Company A, D&A is assumed to be zero, whereas, for Company B, D&A is $10m.

On paper, Company B technically earns “nothing” in terms of operating income (EBIT) while Company A has $20m in EBIT – despite the two having identical EBITDA values.

At first glance, the majority of investors would likely be indifferent to which company is more profitable.

In reality, the non-cash add-back of D&A is the sole cause behind the identical EBITDA values, and concluding that the profitability of the two companies is identical would be a mistake.