At 04:55 PM 7/3/00 +0200, a visitor asked:
Are you familiar with the term EBITDA and do you know:
a). Why it is used as an indicator for new-economy businesses in general?
b). How Depreciations of <Assets directly related to earnings> are handled?

EBITDA stands for Earnings Before Taxes, Interest, Depreciation, and Amortization. It has become wildly popular with the New Economy set. Is it useful? Well… there are many useful financial measurements that are very similar to EBITDA.

EBIAT, earnings before interest, after taxes, is meaningful: it measures raw earning power, independent of financing sources. It measures earnings available to flow to all financial sources.

EBT is a measure of earning power, given current capital structure, but not taking tax management into account. It measures earnings available to flow to the equity holders. When calculating return on equity, use EBT as the earnings number. The return to equity holders is the earnings after netting out interest.

But what of EBITDA? I side with Warren Buffett in considering EBITDA to be a meaningless financial indicator that seriously distorts and misrepresents a business’s earnings. EBITDA has become popular because people want to value businesses which have essentially unviable business models. It’s often been used in biotech, as well, where companies are valued long before they’re shown to be viable enterprises.

The theory is that depreciation is a non-cash expense, and thus should be backed out of earnings before measuring a company’s earning power. However that ignores the fact that cash actually must be spent on assets in order to run the business. Backing out depreciation without adding in cash expenses is akin to claiming that the business’s capital expenditures aren’t relevant in measuring its earning potential. In fact, the very businesses which use EBITDA are typically the ones in which the expenditures are very relevant in measuring the company’s earning potential!

Which would you rather invest in:

  1. a business which requires $100mm in capital expenditures [which presumably you have to supply!] to produce $100,000 in earnings (but backs out depreciation and presents their EBITDA number of $10,000,000 to you)?
  2. a business which requires $10mm in capital expenditures to produce $100,000 in earnings, but leaves the depreciation in and reports an EBIT of $100,000?

The second business will ultimately give you a far better return on your money.

Only where the depreciation or amortization truly represents a non-cash expense does it makes sense to back it out of the equation. When a company is acquired for more than its asset value, the different between the purchase price and asset value is recorded as “good will.” The good will is then amortized over several years. It does make sense to back out this good will, as it doesn’t represent a use of the business’s cash.

Why is EBITDA used in so many new-economy businesses? Many new-economy businesses spend much of their money on hardware and software infrastructure that’s capitalized as an asset on their balance sheet. Using EBITDA lets entrepreneurs and their bankers produce a positive number with the big up-front expenses backed out of the earnings calculation. It’s certainly not fraud, simply creative misrepresentation aimed at investors who in many cases don’t think particularly deeply about the numbers reported by a business.

The practice is sometimes defended by claiming that a one-time large development expense shouldn’t be used to judge the ongoing attractiveness of a business. But many new-economy businesses have not demonstrated that development is a one-time expense. In fact, technology changes so fast that it is fairly certain that a whole new round of hardware and software purchases will be happening every few years.

All this said, if you‘re raising money or going public, EBITDA subtleties may not matter. If investors are willing to give you an EBITDA-based valuation, that’s their decision. But when using your numbers to actually manage the business, remember that capital expenditures are a genuine cost. Removing them from the equation is wishful thinking, nothing more.


EBITDA: The Phantom Measurement. (What's EBIT…

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