Munger, Klarman and Buffett on EBITDA

I was reviewing some of my notes and ran across some of the quotes that I have highlighted regarding commonly used metrics, such as EBITDA, for valuation purposes.

Before going into the direct quotes, here are the main takeaways that are relevant for us as investors.

• Depreciation is a cash expense that is paid up on front
• Interests and taxes are very real expenses and should be taken into account
• Capital expenditures are required for any on-going business. These are hard to predict but necessary to consider

Warren Buffett (Trades, Portfolio) mentioned the following:

“It [depreciation] is reverse float — you lay out money before you get cash. Any management that doesn’t regards depreciation as an expense is living in a dream world, but they’re encouraged to do so by bankers. Many times, this comes close to a flim flam game. People want to send me books with EBITDA and I say fine, as long as you pay cap ex. There are very few businesses that can spend a lot less than depreciation and maintain the health of the business. This is nonsense. It couldn’t be worse. But a whole generation of investors have been taught this. It’s not a non-cash expense — it’s a cash expense but you spend it first. It’s a delayed recording of a cash expense. We at Berkshire are going to spend more this year on cap ex than we depreciate.”

Charlie Munger (Trades, Portfolio), as usual, provides great wisdom with just a few words:

“I think that, every time you saw the word EBITDA [earnings], you should substitute the word “bullshit” earnings. People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.”

And Klarman mentioned the following in Margin of Safety:

“It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. EBIT did not accurately measure the cash flow from a company‘s ongoing income stream. Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful. Those who used EBITDA as a cash-flow proxy, for example. Either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out. In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipated sharp reductions in capital expenditures. Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

It is not easy to determine the required level of capital expenditures for a given business. Businesses invest in physical plant and equipment for many reasons: to remain in business, to compete, to grow, and to diversify. Expenditures to stay in business and to compete are absolutely necessary. Capital expenditures required for growth are important but not usually essential, while expenditures made for diversification are often not necessary at all. Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders. Since detailed capital-spending information was not readily available to investors, perhaps they simply chose to disregard it.”