The Secret CFO

The Secret CFO



EBITDA is a TERRIBLE measure of profitability. Here's why ⬇️⬇️

1/ What is EBITDA? EBITDA is pronounced either "Eee-Bit-Dah" or "Ebb-It-Dah". Or ... for the 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: 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 he is known to his friends. 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. Laser focused on long term shareholder value. Whilst his his peers were obsessed with Net Income & EPS, Malone was playing a different game. He was going the other way, REDUCING Net Profit. Look at him. You f*cking wish, you were that handsome.

7/ He spotted an opportunity to buy up cable assets cheap. He wanted to use every penny for that. That meant higher depreciation expenses (and net profit), but also a lower tax cost. Malone knew this was the right thing for shareholders in the long run. Who’s your EBITDADDY?

8/ So how did he make sure the stock 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 accounting police didn't catch up Financial statements are prepared in line with accounting rules. Those rules were never updated to formalise precisely how EBITDA was to be used or defined. And 35 years on, they still haven't been. The Big 4 don’t want the heat.

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 & comparison issues. Folk often believe they are comparing apples with apples when in fact they aren’t.

12 / In 2019 Desk Space Jesus - Adam Neumann (DSJ) introduced Community Adjusted EBITDA as the lead financial measure during the 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/ Wall Street puked all over it, and the rest is history. This is an edge case, of course. But more subtle manipulations of EBITDA reporting are an every day occurrence. I talked more about this in an earlier thread.

14 / The other problem with EBITDA? One great way of increasing EBITDA ... spending money on capital expenditure and acquisitions to generate returns. Where does the cost for that investment sit? In the 'D' and the 'A' of EBITDA.

15/ So EBITDA recognises all of the good news of capex spend and acquistions and none of the bad. This creates incentive misalignment between management and its investors. You guys know I don’t like mis-aligned incentives.

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

16/ So how do you use EBITDA? First of all, get clear on what’s in and what’s out. ESPECIALLY if you see the word ‘Adjusted’. That is a licence for management to go improv jazz. Restructuring costs, one-off items, SBC, etc. The best analysts I see, all go deep here.

17 / Second. Don’t think about EBITDA like a profit measure. Think about it like the first step in understanding the cashflow. There are some industries where EBITDA is a reasonable proxy to cash flow. But there are more where it is not.

18/ If you are someone who is taking EBITDA at face value, and talking about it as a measure of profitability… That’s cool. We just can’t be friends any more : ( Jarred wouldn’t let you be so reckless and neither will I.

19/ If you want the real truth in business performance Don't look at profit. Look at cashflows. To really understand the value or performance of a business, you must understand its cashflows. Cashflows don't lie. (Well kind of, but I covered that in an earlier thread.)

20/ The value of any business, is only ever the present value of its future cashflows. The challenge is in estimating those cashflows. But, if you don't understand the cashflows, you don't understand the business (or the valuation)

TLDR: - EBITDA is a 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 … Please: 1. Follow @secretcfo for more, and; 2. RT the below tweet to spread the word.

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