The Secret CFO

The Secret CFO

31-08-2022

17:24

EBITDA is a terrible measure of profitability. Yeah that's right. You heard me. Here's why 👇

1/ What is EBITDA? EBITDA is pronounced either "Eee-Bit-Dah" or "Eb-It-Dah". Or ... if you are time rich "Eee-Bit-Dee-Ay" It stands for Earnings Before Interest, Tax, Depreciation, Amortization.

2/ EBITDA is used as a measure of profitability that includes some business costs but not all. Note, that I said it is USED as as measure of profitability. Not that it IS a measure of profitability. More on that later.

3/ EBITDA has a cousin called EBIT (Earnings Before Interest & Tax). It's like EBITDA But After Depreciation and Amortization. EBIT could have been called EBITDABADA. But that would have been stupid. Little CFO joke for you there ...

4/ Why is EBITDA important? EBITDA is important because it is used ... a lot: - Language of investors (equity & credit) - Measuring business unit profitability (and management incentives) - Compare earnings between businesses - Valuation for M&A - and lots more ...

5/ Where did EBITDA come from? EBITDA was invented in the 1980s by legendary telecoms CEO John Malone. Or EBITDADDY as I like to call him ... Malone was frustrated because he felt that EPS (Earnings Per Share) was not the right measure to reflect value in his business.

6/ Malone was a brilliant CEO totally focused on driving long term shareholder value. Whilst his his peers were all obsessed with vanity metrics (Net Income & EPS), Malone was playing a different game. He was going the other way, REDUCING Net Profit.

7/ Why? Because he spotted an opportunity to buy up more cable assets cheap. He wanted to use every penny for that. That meant higher depreciation and amortization expenses, but a lower tax cost. Malone knew this was the right thing for shareholders in the long run.

8/ So how did he make sure the share price got the credit he felt his (genuinely) brilliant plan deserved? He flipped the focus of investors from profit to cashflow. What was the first line in the cashflow that he presented? You guessed it... EBITDA.

9/ So EBITDA was introduced into the finance lexicon as a line in a cashflow statement, not as a profit measure. Wall Street loved this, and it was quickly adopted as a standard across finance. There was a problem though. A big one...

10/ The big problem ... The accounting police didn't catch up Financial statements are prepared in line with accounting rules known today as "IFRS." Those rules were never updated to formalise precisely how EBITDA was to be used. And 35 years on, they still haven't been

11/ So what does that mean? Well it means that EBITDA can be defined, and used in any way that companies, investors and advisors see fit. And that can lead to chaos.

12 / In 2019 Desk Space Jesus - Adam Neumann (DSJ) introduced Community Adjusted EBITDA as the lead financial measure during the ultimately failed IPO of WeWork. Under the surface DSJ's definition of EBITDA was actually closer to revenue than it was any measure of profit.

13 / The other problem with EBITDA? One great way of increasing EBITDA ... spending money on capital expenditure and acquisitions. Where does the cost for that capex and goodwill on acquisitions sit? In the 'D' and the 'A' of EBITDA.

14/ Depreciation = Cost of Capex spread over x years Amortization = Cost of Goodwill on acquisitions spread over x years So EBITDA recognises all of the good news of capex spend and acquistions and none of the bad.

15/ And I'll tell you who loves EBITDA more than anyone? CEOs. Especially CEOs who are measured on EBITDA who love spending money on capital expenditure and acquisitions. They fucking love it. "Who's paying for that capex boss... the tooth fairy?"

15/ So what profit measure should you use? EBIT is certainly better than EBITDA as measure of trading performance. Although, comparing EBIT between business can be warped by differing depreciation policies. So it's not perfect.

16 / I like EBITDA less Reasonable Maintenance Capex Expenses as an internal measure. (EBITDALRM.... ok I'll stop) And if the accounting regulatory bodies got their ass moving, they'd define it in a way that it could be used externally and comparably.

17/ But, if you want the real truth. You don't look at profit. You look at cashflow. To really understand the value or performance of a business, you must understand its cashflows. Cashflows don't lie. (Well kind of, but that's for another thread).

The value of any business, is only ever the present value of its future cashflows. The challenge is in estimating those cashflows. Profits can sometimes be used carefully as a proxy to cashflow But, if you don't understand the cashflows, you don't understand the business

TLDR: - EBITDA is the most widely used profit measure - But it's flawed as a measure of profitability - It doesn't reflect capex costs - And the accountants don't have any hard rules on how it's stated - Cashflows are the only way to really understand a business performance

Ok, I'm EBITDONE with this one. If you enjoyed this thread: 1. Follow me @SecretCFO for more of these 2. RT the tweet below to share this thread with your audience



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