Buffett Lambasts EBITDA, But What Earnings Measurement Is Best?

Making sense of the acronyms…

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Some say that valuation techniques go in and out of style. Traditional investors look a the P/E ratio, but now buzzwords like return on invested capital (ROIC) and cashflow return on investment (CFROI) are catching on.

In addition, over the last few years — thanks to the glitz of the M&A world where deals are quoted in EV/EBITDA (enterprise value divided by earnings before interest, tax, depreciation and amortisation) terms — we see earnings per share (EPS) being displaced by EBITDA.

Of course, traditional punters began to scoff (correctly, in my opinion) that it’s not difficult to find a near-worthless firm with bulky EBITDA numbers. A quick glance at Premier Foods‘ financials is all the proof we need.

Passive income stocks: our picks

Do you like the idea of dividend income?

The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…

Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.

What’s more, today we’re giving away one of these stock picks, absolutely free!

Get your free passive income stock pick

More importantly, Warren Buffett has been an ardent critic of EBITDA. His criticism, in general terms, comes down to three points: EBITDA does not account for depreciation, taxes and interest payments, which are all very real costs to the company. His observations are consistent with latest academic thinking, and most investors these days should have a copy of Valuation Measuring and Managing Value of Companies next to the Intelligent Investor.

Consequently, when I have time for a proper model and valuation, my preferred measure of profits is Net Operating Profit Less Adjusted Taxes (NOPLAT). In effect, it is a ‘lower down the profit and loss (P&L)” derivative of EBITDA that includes both depreciation, operational amortisation and recognises the tax expense. I usually follow my analysis with a debt and liquidity assessment, after forecasting of capital expenditure and net working capital.

Nonetheless, EBITDA continues to litter the financial press, so it must have some merits. Chiefly, I would argue, it can represent a rough-and-ready measure of NOPLAT, and can be helpful in two ways. First of all, it’s useful for comparing companies in a similar industry within a single country. For instance, retailers or telecoms in the UK all face similar tax rates and would find it difficult to differentiate themselves in terms of real investments they make. Thus, comparing the EV/EBITDA ratios of these firms is a good start for measuring their value, especially when debt levels are low.

Also, note that Mr Buffett’s criticism is a bit US-centric. Tax code is very complex Stateside, and the use of operating leases is more pronounced. This allows accountants to play tricks: some may add value by lowering taxes, and some may be borderline fraudulently obfuscating the asset base. Secondly, I find the change of EBITDA margins as good representation of trends in operating costs and operating leverage of a company. It is useful for measuring past performance and helps with modelling of future profit.

What about using EPS and the good-old-fashioned price-to-earnings (P/E) ratio? It clearly side-steps all of Mr Buffett’s criticisms. Valuation academics would say that this measure is less suited to making comparisons. It’s sensitive to a company’s leverage, a CFO’s subjective choice, and varies from firm to firm and across time. EV/NOPLAT is popular among the theorists because it approximates the P/E ratio in a scenario when a firm is financed only by equity.

I would raise another point: calculating EPS that correctly adjusts for temporary P&L items is difficult and time-consuming. Even if companies do report ‘core’ EPS, it takes a lot of effort to untangle. Assessing valuation, at least initially, with EBITDA or EBIT figures just seems easier.  

Many companies, especially in the UK, understand the thinking described above. That is why many report non-generally accepted accounting principles items such as inter alia ‘Trading Profit’ or ‘Adjusted EBIT(A)’. However, although these items are very close to pre-tax NOPLAT, looking at the items they omit or ‘adjust’ is not a bad idea…

Passive income stocks: our picks

Do you like the idea of dividend income?

The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…

Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.

What’s more, today we’re giving away one of these stock picks, absolutely free!

Get your free passive income stock pick

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

More on Investing Articles

Older couple walking in park
Investing Articles

Could £300 a month invested in US and UK shares reach a million by retirement?

Could an investor retire with a million pounds just by dedicating £300 a month to US and UK shares? Mark…

Read more »

Young Caucasian man making doubtful face at camera
Investing Articles

Is £800 enough to start an ISA?

Is it worth bothering with an ISA with less than £1,000 to spare? This writer believes it may be --…

Read more »

Investing Articles

3 reasons Tesla stock may be a long-term bargain

This writer is keen to buy Tesla stock at the right price. He doesn't think it's there yet -- but…

Read more »

Investing Articles

Nvidia stock is a lot cheaper than before – or is it?

Nvidia stock has been caught in the whirlwind of market volatility. This writer has been waiting to buy, so might…

Read more »

Top Stocks

3 FTSE stocks Fools are eyeing up for choppy markets

A selection of companies listed on the UK stock market on the watchlists of four Foolish investors.

Read more »

Young Black man sat in front of laptop while wearing headphones
Investing Articles

A £10,000 investment in Rolls-Royce shares last week is now worth this…

Harvey Jones says Rolls-Royce shares couldn't escape the volatility of recent weeks, but wonders if the recent dip is a…

Read more »

The flag of the United States of America flying in front of the Capitol building
Investing Articles

Prediction: in 2 years these S&P 500 stocks will be much higher than they are today

These two S&P 500 stocks have been beaten down in recent weeks. But Edward Sheldon expects them to move much…

Read more »

Investing Articles

10% yields! Why a volatile stock market is great news for passive income investors

The recent stock market volatility has given passive income investors the chance to earn double-digit returns. But they still need…

Read more »