Fighting EBITDA

The best way to think about financial statements is always to ground them in investment theory. The question of value creation is fundamental if we are trying to understand the economic performance of a company. The starting point is to measure the return the company is earning on investors’ capital, and then compare that to the cost of capital. Measuring return on capital brings intellectual coherence to reading financial statements – it forces us to think about the integrity of the accounting data, and it counters our preoccupation with income by bringing the balance sheet centre stage.

For financial statements to provide the data integrity of a properly conducted investment appraisal we need income to be comprehensive and the balance sheet to give a complete account of the assets and liabilities of the firm. And we would need those assets and liabilities to be measured at their opportunity cost to the investor – call this current value. 

US GAAP and International Financial Reporting Standards (IFRS) have both made a lot of progress on the first two. Companies now clearly account for their comprehensive income, and the balance sheet is much more complete than it was. The final step will be to capitalize operating leases. 

Then GAAP will probably have gone as far as it is going. GAAP has a fundamental bias towards conservatism, and thus towards understating equity. So balance sheets will continue to omit home-grown intangibles and continue to prefer historical cost for recording assets. Income statements will seek to anticipate costs and postpone the recognition of gains. My own view is that we can easily live with GAAP‘s conservatism as long as we understand it.

What about the users? 20 years ago was the heyday of the ‘shareholder value’ movement, and return on capital thinking was naturally at the centre of that. The consulting firms already had big value management practices: they spent a lot of time developing proprietary metrics, such as Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI), and thinking about the integrity of the accounting numbers that went into them. In the investor world, both the buy side and the sell side started to use these tools to give them a competitive edge, and anyhow value investing demands a return on capital approach.

Unfortunately, the Enron failure in 2001 had unforeseen consequences for analyst practice, at least on the sell side. Enron perfectly demonstrated the need for good fundamental analysis. But the reforms that the then-New York Attorney General Eliot Spitzer and others pushed through in the aftermath eventually had the effect of stripping a lot of resource out of the sell side so that, now, there are observably fewer analysts publishing fundamental research. 

In parallel, there appears to be a loss of focus on the rigorous measurement of income and of return on capital. This is nowhere so evident as in the cult of EBITDA (earnings before income tax, depreciation and amortization).

EBITDA’s popularity grew in the late nineties when, coincidentally, there were many loss-making technology businesses trading on the market at sky high valuations. Because EBITDA always gave a more cheery number than EBIT or earnings, it provided a useful basis for valuation multiples. 

EBITDA is part of the story – used with care it can be a useful in isolating the relationship between revenues and a certain subset of costs. However, and worryingly, EBITDA has become the story for many companies, analysts and commentators. EBITDA makes unprofitable businesses look profitable and, moreover, is very vulnerable to creative accounting. Because EBITDA ignores depreciation, as well as interest, taxes and amortization, it is not in any sense a measure of income. Because EBITDA ignores working capital and capex – in other words ignores the balance sheet – it is not a measure of cash flow. As Warren Buffett put it: Does management think the tooth fairy pays for capital expenditures?

So while I do believe that financial statements have got better over the last 20 years, it is not so clear that people are using them better. That is a continuing battle!