Posts tagged ‘depreciation’

EBITDA: Sniffing Out the Truth

Sharp eyed soft nosed cow, with shallow dof

Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers, EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric.

The Genesis of EBITDA

The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying high interest expenses could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.

The Advantages of EBITDA

Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:

  • Operational Comparability:  As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
  • Cash Flow Proxy:Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
  • Debt Coverage Ratios:In many lender contracts, certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.

The Disadvantages of EBITDA

While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.

  • Overstates Income:  To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality by measuring income before a bunch of expenses. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTERaccounting for all expenses, including interest expense, depreciation expense, and income tax expense.
  • Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
  • Poor for ValuationInvestment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).

Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.

investment-questions-border

Wade W. Slome, CFA, CFP®

www.Sidoxia.com

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

 

September 17, 2016 at 11:44 pm 4 comments

Monitoring the Tricks Hidden Up Corporate Sleeves

Cheating

As Warren Buffett correctly states, “If you are in a poker game and after 20 minutes, you don’t know who the patsy is, then you are the patsy.” The same principle applies to investing and financial analysis. If you are unable to determine who is cooking (or warming) the books via deceptive practices, then you will be left holding a bag of losses as tears of regret pour down your face. The name of the stock investing game (not speculation game) is to accurately gauge the financial condition of a company and then to correctly forecast the trajectory of future earnings and cash flows.

Unfortunately for investors, many companies work quite diligently to obscure, hide, and distort the accuracy of their current financial condition. Without the ability of making a proper assessment of a company’s financials, an investor by definition will be unable to value stocks.

There are scores of accounting tricks that companies hide up their sleeves to mislead investors. Many people consider GAAP (Generally Accepted Accounting Principles) as the laws or rules governing financial reporting, but GAAP parameters actually provide companies with extensive latitude in the way accounting reports are implemented. Here are a few of the ways companies exercise their wiggle room in disclosing financial results:

Depreciation Schedules: Related to GAAP accounting, adjustments to longevity estimates by a company’s management team can tremendously impact a company’s reported earnings. For example, if a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year ($10m ÷ 10 years). If for some reason the Chief Financial Officer (CFO) suddenly changes his/her mind and decides the building should last 40 years rather than 10 years, then the company’s annual expense would miraculously decrease -75% to $250,000. Voila, an instant $750,000 annual gain created out of thin air! Other depreciation tricks include the choice of accelerated or straight-line depreciation.

Capitalizing Expenses: If you were a management team member with a goal of maximizing current reported profitability, would you be excited to learn that you are not required to report expenses on your income statement? For many the answer is absolutely “yes”.  A common example of this phenomenon occurs with companies in the software industry (or other companies with heavy research and development), where research expenses normally recognized on the income statement get converted instead to capitalized assets on the balance sheet. Eventually these capitalized assets get amortized (recognized as expenses) on the income statement. Proponents argue capitalizing expenses better matches future revenues to future expenses, but regardless, this scheme boosts current reported earnings, and delays expense recognition.

Stuffing the Channel: No, this is not a personal problem, but rather occurs when companies force their goods on a distributor or customer – even if the goods (or service) are not requested. This deceitful practice is performed to drive up short-term revenue, even if the reporting company receives no cash for the “stuffing”. Ballooning receivables and substandard cash flow generation can be a sign of this cunning, corporate custom.

Accounts Receivable/Loans: Ballooning receivables is a potential sign of juiced reported revenues and profits, but there are more nuanced ways of manipulating income. For instance, if management temporarily lowers warranty expenses and product return assumptions, short-term profits can be artificially boosted. In addition, when discussing financial figures for banks, loans can also be considered receivables. As we experienced in the last financial crisis, many banks under-provisioned for future bad loans (i.e. didn’t create enough cash reserves for misled/deadbeat borrowers), thereby overstating the true, underlying, fundamental earnings power of the banks.

Inventories: As it relates to inventories, GAAP accounting allows for FIFO (First-In, First-Out) or LIFO (Last-In, Last-Out) recognition of expenses. Depending on whether prices of inventories are rising or falling, the choice of accounting method could boost reported results.

Pension Assumptions: Most companies like their employees…but not the expenses they have to pay in order to keep them. Employee expenses can become excessively burdensome, especially for those companies offering their employees a defined benefit pension plan. GAAP rules mandate employers to contribute cash to the pension plan (i.e., retirement fund) if the returns earned on the assets (i.e., stocks & bonds) are below previous company assumptions. One temporary fix to an underfunded pension is for companies to assume higher plan returns in the future.  For example, if companies raise their return assumptions on plan assets from 5% to a higher rate of 10%, then profits for the company are likely to rise, all else equal.

Non-GAAP (or Pro Forma): Why would companies report Non-GAAP numbers on their financial reports rather than GAAP earnings? The simple answer is that Non-GAAP numbers appear cosmetically higher than GAAP figures, and therefore preferred by companies for investor dissemination purposes.

Merger Magic: Typically when a merger or acquisition takes place, the acquiring company announces a bunch of one-time expenses that they want investors to ignore. Since there are so many moving pieces in a merger, that means there is also more opportunities to use smoke and mirrors. The recent $8.8 billion write-off of Hewlett-Packard’s (HPQ) acquisition of Autonomy is evidence of merger magic performed.

EBITDA (Earnings Before Interest Taxes Depreciation & Amortization): Skeptics, like myself, call this metric “earnings before all expenses.” Or as Charlie Munger says, Warren Buffett’s right-hand man, “Every time you see the word EBITDA, substitute it with the words ‘bulls*it earnings’!”

This is only a short-list of corporate accounting gimmicks used to distort financial results, so for the sake of your investment portfolio, please check for any potential tricks up a company’s sleeve before making an investment.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in HPQ/Autonomy,  or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

February 24, 2013 at 12:54 am 1 comment

EBITDA: Sniffing Out the Truth

Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric. 

The Genesis of EBITDA

The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying interest expense could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.  

The Advantages of EBITDA

Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:

  • Operational Comparability:  As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice. 
  • Cash Flow Proxy: Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
  • Debt Coverage Ratios:  In many lender contracts certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.

The Disadvantages of EBITDA

While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.

  • Overstates Income:  To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and  income tax expense.
  • Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
  • Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).

Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

April 6, 2010 at 11:00 pm 1 comment


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