Why Charlie Munger Despised EBITDA

Discover why Berkshire Hathaway's vice chairman, Charlie Munger, despised EBITDA and learn how this metric can mislead investors. Delve into the historical context, Munger and Buffett's critique, and alternative metrics favored by the duo. Gain valuable insights into financial analysis and the importance of transparency in reporting.

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Introduction

Charlie Munger, former vice chairman of Berkshire Hathaway ↗ and Warren Buffett's long-time business partner, was known for his sharp wit and even sharper investment philosophy. Among the financial metrics that have drawn his ire, EBITDA stands out as a particular target of his disdain. This measure of financial performance, while popular in certain circles, has been criticized by Munger and Buffett for its failure to account for several key expenses that can significantly impact a company's real earning power. Their skepticism is not just a matter of personal preference but is rooted in a deep understanding of what truly indicates a company's financial health.

The objective of this article is to delve into the reasons behind Charlie Munger's, and by extension Berkshire Hathaway's, aversion to EBITDA. Through exploring the historical context of this financial metric, detailing Munger and Buffett's critique, and examining the broader implications for investors, this piece aims to provide a comprehensive understanding of why EBITDA may not be the golden measure it's often made out to be. We will also touch upon alternative metrics preferred by Munger and Buffett that offer a more accurate reflection of a company's financial standing ↗.

As we journey through this exploration, we will weave in historical, political, and economic insights that shed light on the evolution of financial metrics and their impact on investment strategies. Prepare for a thorough, interesting, and entertaining exploration into the world of finance through the eyes of two of its most esteemed figures.

The Invention and Rise of EBITDA

The story of EBITDA, an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization, begins in the 1970s with John Malone, the Chairman of Liberty Media. Malone invented EBITDA to assist in selling lenders and investors on his leveraged growth strategy ¹. At its core, EBITDA was designed to simplify the assessment of business performance by excluding costs related to financing, taxes, and the depreciation and amortization of assets from a company's earnings. Its simplicity and seemingly clear representation of operational profitability made it an attractive metric for companies and investors alike.

EBITDA's popularity soared as it began to be used in valuation ratios, notably the enterprise value to EBITDA ratio (EV/EBITDA), which became known as the enterprise multiple ¹. This widespread adoption occurred despite EBITDA not being recognized under generally accepted accounting principles (GAAP), highlighting its appeal to those looking to present a more favorable view of a company's financial performance.

However, the non-GAAP nature of EBITDA means its calculation can vary significantly from one company to another, leading to inconsistencies and potential misinterpretations ¹. Despite these issues, EBITDA gained traction, partly due to the economic and financial landscape of the 1970s, which may have made such a simplified metric particularly appealing to companies and investors navigating the complexities of that era.

Munger and Buffett's Critique

Warren Buffett and Charlie Munger's skepticism towards EBITDA stems from a fundamental disagreement with the metric's exclusion of key expenses. They argue that depreciation, while a non-cash expense, represents a real cost of doing business, as it accounts for the gradual loss of value of a company's assets ³⁴. Ignoring such costs, in their view, provides an incomplete and overly optimistic picture of a company's financial health.

Munger has been particularly vocal about his disdain for EBITDA, famously describing it as "horror squared" and criticizing its users as either attempting to deceive or being self-deceived ³. Charlie Munger has even used more explicit language to "describe" EBITDA; readers may already be aware of the terms he used... ²⁵.

Munger and Buffett view the metric as a tool invented by investment bankers to make deals appear more attractive than they are in reality ³. This critique is part of a broader philosophical stance that favors a comprehensive understanding of a company's financial performance over simplified metrics that can obscure more than they reveal.

Buffett contrasts EBITDA with the concept of float, a key component of Berkshire Hathaway's success, which involves using money that doesn't belong to the company to generate earnings ³. This juxtaposition highlights their preference for financial metrics that account for all aspects of a company's operations, including costs and sources of income that EBITDA conveniently ignores.

Buffett said ²: "People who use EBITDA are either trying to con you or they’re conning themselves."

Their critique was not just philosophical but was grounded in a concern for the impact of misleading accounting practices on the industry. Buffett and Munger outlined EBITDA, as a "very misleading statistic," which can lead to pernicious effects, encouraging a culture of earnings manipulation and short-termism that ultimately harms investors and the market as a whole ⁴.

Warren Buffett is very suspicious of unclear or vague management reporting ⁹ as it is the case with EBITDA "earnings". In his Chairman Letter from 2000 ⁹, Buffett explicitly applauded Arthur Levitt, Jr., then recently retired Chairman of the SEC, to have cracked down on the corporate practice of "selective disclosure" that had "spread like cancer in recent years". EBITDA is exactly that - a selective disclosure, or, say, might-be-earnings.

Thus, Munger and Buffett's critique of EBITDA was rooted in their belief in the importance of transparency, comprehensiveness, and realism in financial reporting. By highlighting the metric's shortcomings, they advocated for a more nuanced approach to evaluating a company's financial performance, one that considers all costs and sources of income to provide a true picture of its economic health.

The Misleading Nature of EBITDA

EBITDA, has been a popular metric among investors and analysts for assessing a company's operational profitability. However, its utility as a reliable indicator of financial health is highly controversial. As we have discussed, critics such as Charlie Munger and Warren Buffett, argue that EBITDA can significantly distort a company's financial reality, making it appear more profitable and less expensive than it truly is ¹⁶.

One of the primary criticisms is that EBITDA ignores critical costs such as depreciation and amortization—expenses that reflect the real cost of capital assets over time. Warren Buffett has notably criticized EBITDA for this reason, emphasizing that depreciation is not merely an accounting convention but a genuine cost ¹. Furthermore, the calculation of EBITDA can vary significantly from one company to another, leading to inconsistencies and confusion among investors ¹.

The reliance on EBITDA has led to valuation discrepancies, as seen in the case of Sprint Nextel, which traded at 7.3 times its forecast EBITDA but at much higher multiples of forecast operating profits and net income ¹. This discrepancy highlights how EBITDA can make a company appear much less expensive than it really is. Hedge fund manager Daniel Loeb's criticism of the use of adjusted EBITDA and adjusted earnings underscores the potential for manipulation and misrepresentation ¹.

Moreover, the focus on EBITDA has been linked to some of the most notorious financial scandals in history. Lynn Turner, a former chief accountant at the SEC, argued that the emphasis on EBITDA allowed financial misdeeds at companies like WorldCom, Enron, and Sunbeam to go unnoticed ⁶. This point is further supported by the SEC's stance on EBITDA, requiring companies to reconcile any reported EBITDA figures with net income to ensure transparency and prevent misleading reporting ¹.

The Case of Bank of America

The financial results of Bank of America for FY 2023 serve as a pertinent case study in understanding the limitations of EBITDA ↗↗. The bank reported total revenue, net of interest expense, of $98.6 billion, with a noninterest expense of $65.8 billion, leading to a pretax income of $28.3 billion. The net income stood at $26.5 billion after accounting for an income tax expense of $1.8 billion ⁸. Notably, Bank of America did not provide an interest expense figure for FY 2023, which is a critical omission when considering the relevance and meaning of EBITDA.

Discussing earnings without considering interest expenses, as EBITDA does, would obscure the true financial picture of a company like Bank of America. Interest expense is a significant cost for banks, given their reliance on borrowed funds. Excluding this expense could misleadingly inflate the appearance of operational profitability. This case underscores the importance of considering all aspects of a company's finances, beyond just EBITDA, to gain a comprehensive understanding of its financial health. ↗

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Beyond EBITDA: Munger and Buffett's Preferred Metrics

Charlie Munger and Warren Buffett advocate for a more comprehensive approach to financial analysis, favoring metrics that account for all costs, including capital expenditures and other real expenses ↗. They emphasize the importance of full and fair reporting, which includes a thorough discussion of significant data necessary to interpret a company's financial information ⁹.

Buffett famously said: "Beware of geeks bearing formulas." That quote can be interpreted such that understanding a business is much more than a single metric or mathematical approach. Instead of EBITDA, Munger and Buffett preferred metrics such as operating cash flow and free cash flow in frame of a complete understanding of the underlying business of the company in question. Operating cash flow, for instance, is considered a better measure of a company's cash-generating ability as it adds non-cash charges back to net income and includes changes in working capital ¹. This metric provides a more accurate picture of the financial health and sustainability of a company.

Furthermore, Munger and Buffett cautioned against relying on predictive growth rates, advocating for a focus on sustainable earnings power. Their investment strategy reflects these principles, prioritizing companies with transparent reporting and a solid track record of generating real, sustainable profits over those presenting overly optimistic forecasts based on adjusted metrics like EBITDA.

The insights of Munger and Buffett on financial analysis and reporting serve as a valuable guide for investors and analysts. By moving beyond EBITDA and embracing a more comprehensive approach to financial metrics, investors can gain a deeper understanding of a company's true financial health and make more informed investment decisions.

Implications for Investors and Analysts

The reliance on EBITDA as a singular measure of company performance is fraught with dangers, a reality that has been underscored by the experiences of companies like Vivendi, Cablevision Systems, and Crown Castle International, which showcased healthy EBITDA figures while suffering from negative free cash flow ⁶. This discrepancy highlights a critical flaw in EBITDA: its inability to account for interest costs, taxes, capital expenditures, and the nuances of working capital requirements ⁶⁷. Such oversights can lead to a gross misrepresentation of a company's financial health, potentially leading investors and analysts down a perilous path.

For investors and analysts, the allure of a simplified metric like EBITDA is understandable, yet it's imperative to resist the temptation to use it in isolation. The guidance here is to employ a more holistic set of metrics that encompass not only operational profitability but also the financial obligations and operational needs of a company. This approach ensures a comprehensive understanding of a company's financial health, beyond the superficial gloss of high EBITDA figures.

Skepticism and due diligence are, therefore, indispensable tools in the financial analyst's toolkit. The lessons from financial scandals such as WorldCom, Enron, and Sunbeam, where an undue focus on EBITDA allowed significant irregularities to slip through the cracks, underscore the importance of a critical approach to financial analysis ⁶. Regulatory bodies play a crucial role in ensuring financial transparency and protecting investors, but it is ultimately the responsibility of investors and analysts to look beyond headline numbers.

Investors should ask probing questions when presented with EBITDA figures: What are the capital expenditures? How does the company manage its working capital? What are the interest and tax burdens? By asking such questions, investors can gain a deeper understanding of a company's financial health.

A checklist for evaluating company performance beyond EBITDA might include:

• Analysis of free cash flow to understand the actual liquidity position.
• Examination of debt levels and interest expenses to assess financial stability.
• Review of capital expenditures to gauge future growth prospects.
• Consideration of tax obligations to understand net profitability.
• Assessment of working capital management to evaluate operational efficiency.

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Conclusion

Throughout this article, we have explored why Charlie Munger, alongside Warren Buffett, harbored a deep-seated aversion to EBITDA as a measure of company performance. Their skepticism stems from EBITDA's glaring omissions—interest, taxes, depreciation, and amortization—elements that are fundamental to understanding a company's true financial health. Companies with seemingly robust EBITDA figures, such as Vivendi with its negative free cash flow of $6.5 billion despite impressive EBITDA, served as cautionary tales of the metric's misleading nature ⁶.

The implications for investors and analysts are clear: reliance on EBITDA alone is a precarious basis for investment decisions. A more comprehensive approach, incorporating a broader set of financial metrics and a healthy dose of skepticism, is essential for a true assessment of company performance. This approach aligns with the regulatory mandate for financial transparency and investor protection, but it also requires individual diligence in financial analysis.

In closing, let us heed the wisdom of Munger and Buffett's approach to investing and financial analysis. Their enduring skepticism towards EBITDA and advocacy for a comprehensive, nuanced understanding of financial health offered invaluable lessons. As investors and analysts, we are encouraged to apply these lessons in our practices, striving for more transparent and meaningful financial reporting.

For those seeking to delve deeper into Berkshire Hathaway's investment philosophy, further reading and exploration of Munger and Buffett's writings and speeches are highly recommended. Their insights into financial analysis, beyond the superficial allure of simplified metrics like EBITDA, are both profound and practical.

In the words of Warren Buffett ⁹, "Does management think the tooth fairy pays for capital expenditures?" This rhetorical question encapsulates the critical perspective we must adopt towards EBITDA and financial analysis at large. It's a reminder that in the complex realm of financial metrics, a discerning, comprehensive approach is not just beneficial—it's essential.

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