Warren buffet on EBITDA !What is ADJUSTED EBITDA ?

In its quarterly reports, Uber uses ‘EBITDA’ heavily.

Its rival, Lyft also uses EBITDA similarly.

In fact, almost all new tech companies stress on EBITDA. Several non-tech companies too.

And then you have people like Charlie Munger and Warren Buffett who say, “I think that every time you see the word EBITDA, you should substitute the word bullsh*t earnings”.

What’s the deal with EBITDA?

Why do so many companies use it? And why does Warren Buffett not like it?

EBITDA

In basic terms, it’s like your salary – the one that the company says it is paying you. Your ‘CTC’.

It does not account for your taxes or EMIs or bills.

The full form of this is Earnings Before Interest, Taxes, Depreciation, and Amortisation.

Let’s go a bit deeper.

Interest: the company would have borrowed money. This is the amount it needs to pay back.

Taxes: the company owes the government some taxes.

Depreciation: the company owns assets. These would differ from industry to industry. But the assets lose value over time. Like say a company car – it would lose its value with time.

Companies have machinery, vehicles, computers, and even furniture that lose value with time.

Amortization: this refers to the cost of intangible assets like patents, copyrights, etc.

So, EBITDA talks of a company’s earnings before all of the above expenses have been paid.

Why EBITDA?

Here’s where it gets confusing.

What is the point of using EBITDA? Why use EBITDA and not just net profits or earnings?

Well, EBITDA is a lovely tool for acquirers.

If you’re buying a company – not as an investor but more as an acquirer – it tells you something about its future potential.

A company may be making losses at present. But, many of those expenses might be temporary.

Maybe once the company has paid back its debt, it’ll be very profitable.

Or maybe there is a one-time temporary problem because of which a company is not making good earnings.

There was a natural disaster or fire because of which it is having to repurchase a lot of equipment. Or the season was unusually bad.

Something like that.

So, earnings in the case of such companies will be negative. But if the EBITDA is good, it shows future promise.

That makes it attractive to someone who wants to own the company.

Adjusted EBITDA

Now, all that’s written above might sound reasonable to many – and that’s okay.

But there’s a limitation of EBITDA.

It measures earnings without interest, tax, depreciation, and amortization.

But what if there’s a one-time expense or a temporary expense that does not fit those categories? Then what?

In that case, EBITDA is failing to show the potential of a company.

This is where ‘adjustments’ come in. Adjusted EBITDA.

‘Adjustments’ can include other things.

Say, the company is fighting a big court case. One-time legal fees of that. Maybe an international company lost some money because of sudden changes in the exchange rate. Maybe there’s a one-time exercise where a company bought back shares from its employees.

‘Adjustments’ is flexible and subjective. It allows for the accounting of expenses that are unique to different industries.

That’s great.

But it also allows for a lot of nonsense to be included in the calculations.

Maybe money was used to buy luxuries that weren’t needed in a company that was struggling.

In fact, accounting trickery has also been used in clever ways to simply hide losses!

This is why ‘adjusted’ EBITDA has become a source of memes in the finance world. And this is why you as an investor need to read companies’ reports carefully.

Make no mistake, ‘adjustments’ does not mean something is wrong. It can and is used correctly to justify unusual expenses.

But it is also used to hide what shouldn’t be hidden.

Start-Ups and New Businesses

Start-ups and new businesses often run losses in their early days – to develop for the future.

For them, EBITDA is a golden metric.

It allows them to offset one-time costs like the costs of setting up a new company.

It allows them to show that once the set up is complete and the company ready, they’ll indeed be an earnings-making company.

But then, some companies that just don’t have good business models can (and do) use adjustments and EBITDA to hide the fact that they’re not good businesses.

Warren Buffett is more extreme in his beliefs.

He dislikes EBITDA altogether.

Why should you want to know the earnings of a company without its interest payments, depreciation, and amortization?

Interest needs to be paid back. It is unavoidable. Taxes will always be there. Depreciation is a hard reality in this world.

Why should they not be calculated?

But that’s how he thinks. Not all investors.

The investment world is complicated and there can exist many different ways of doing something.

The case of EBITDA highlights something that almost every successful investor will tell you – whether he/she is talking about EBITDA or something else.

Individual numbers, metrics, and ratios will never tell you enough.

Read, research, and understand the company before you buy its shares.