EBITDA Indicates a Company's Financial Performance

Investing Lesson 4 - Analyzing an Income Statement

ebitda cash flow
Many investors mistakenly believe EBITDA is a substitute for free cash flow. Nothing could be further from the truth! EBITDA assumes a company doesn't have to pay for its equipment and capital expenditures, taxes, or interest. That's crazy.

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA

EBITDA tells an investor how much money a company would have made if it didn't have to pay interest expense on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company's financial performance, not free cash flow as many investors incorrectly assume, originally coming into existence in the 1980's during the leveraged-buyout frenzy that epitomized the era of greed.

The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.

In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don't exist is the same mentality of the five-year-old who believes no one can see them when their eyes are closed - while they may enjoy pretending for awhile, the IRS and the banks and bondholders who lent money to the company aren't interested in playing games. When the bills come due, these entities want the money owed to them and can force a company into bankruptcy if they aren't paid.

Still not convinced?

Picture this scenario:

A single man in his mid-twenties, earning $30,000 annually, walks into his local bank to get a loan for a new, top-of-the-line BMW. Each year, he pays $8,100 in taxes, reducing his monthly check from $2,500 to $1,825 (for simplicity sake, let's ignore payroll deductions, etc.) He currently has a mortgage payment of $1,100 per month, and a student loan payment of $200 per month.

After paying all of these expenses, he has $525 on which to live*.

The loan officer crunches the numbers and comes up with an estimated monthly payment of $750 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. "Sir," she says, "you only make $525 a month after payments and taxes! You can't afford this loan. Not only can you not afford the payment, you will then have nothing to live on." The man looks confused, "but I make $2,500 per month before my payments and taxes."

See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely won't. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.

The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can't make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn't be attained, they created a new one that made them appear successful.

In the accounting and business world, EBITDA is a firestorm of controversy.

There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn't worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don't worry about it - four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it's folly such as this that presents us with the opportunity to profit in the market.

*$2,500 monthly pay - $625 taxes - $1,100 mortgage payment - $200 student loan payment = $525 free cash.