Previously we explained Warren Buffett’s Owner Earnings which focuses on the free cash flow. EBITDA can give a dangerous perspective of the financial health of a company. In this article we look at a couple of examples of businesses to see if they generate cash. Multiple sources are used to explain this crucial factor for correctly assessing the financial health of a company.
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Free Cash Flow versus EBITDA
EBITDA means earnings before interest taxes depreciation and amortization. EBIT can be found on the income and loss statement after the company has deducted the costs of goods sold (the gross profit) and the operational costs (e.g. sales, general and administrative costs and Research and Development costs).
Depreciation is the result of writing of the assets (e.g. machines). The costs were already made upfront and can be written-off the earnings via a depreciation schedule. This is often 10 years depending on the asset (e.g. a building is assumed to last longer than a machine). So, a machine that costs $1000 can be written-off by subtracting $100 each year from the revenue of a company.
It is crucial to grasp that deprecation comes due to previous spending of cash on a new asset and then receiving deductions later on. Amortization comes from goodwill. Goodwill is the result of buying a company for a value that is higher than the book value (or equity value). This is logically the case if you buy a business that has high returns on its book. The focus of this article is on deprecation.
EBITDA can lead to overvaluation
Capital expenditures (CAPEX) are crucial for businesses. CAPEX relate to the assets of a business. This can be seen on the left site (the assets) of the balance sheet. The CAPEX (or plant, property and equipment) is depreciated (deducted) which is shown on the income statement as depreciation. Ignoring CAPEX means that you ignore maintenance costs for the machines and plant(s) that operate the business.
Depreciation costs can be lower, the same or higher than the real capital outlays that a business requires to keep its production levels. Presenting the cash available to shareholders in the form of EBITDA can create a false sense of the available cash. As capital expenditures are needed to preserve the earnings power of the company. Machines will wear out over time and property needs to be updated to keep up with the competition. This money will not be available to retain, to pay off debt, for buy-backs or for dividends.
EBITDA is not the focus of a good business
Good businesses don’t have to focus on EBITDA. Instead they will show the Free Cash Flow which incorporates the capital expenditures. The chance that Buffett will buy a business when the owner starts talking about EBITDA is zero (Youtube link).
Some businesses try to increase the net income by listing operational expenses (OPEX) as CAPEX. OPEX is listed on the income statement while CAPEX is listed on the balance sheet. Hence, CAPEX is not deducted from the earnings on the income statement. But does show up on the cash flow statement.
Warren Buffett on EBITDA and its nonsense
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.Warren Buffett, 2002 Annual Report
The depreciation is similar to the maintenance CAPEX for businesses like Coca Cola. EBITA (not adding back depreciation as non cash expense) is such a case could be a good approximation of the cash flow. Especially as the amortization of goodwill might underestimate the growth in value of the assets of superb companies. That is, the created goodwill due to paying more than book value is well worth the buy due to the high rates of return that can be achieved. Goodwill that produces higher returns of the assets in comparison to the market is called economic goodwill.
In 1989 Buffett also mentions that EBITD is no good test for seeing whether a company can pay its interest requirements. Ignoring depreciation as an expense is delusional as 95% of the American businesses need CAPEX equal roughly to the depreciation over time. These costs are just as real as labor or raw material costs.
EBITDA versus earnings – a simple example from Seth Klarman’s book Margin of Safety
Business A has a revenue of $100 and $80 of expenses and $0 amortization and depreciation.
Business B has a revenue of $100 and $80 of expenses and $20 amortization and depreciation.
This means that both companies have an EBITDA of $20, but company A has earnings of $20 and company B of zero! At the same price, company A is clearly better. This could be a service company and company B could be an industrial company with large CAPEX requirements that show up in the depreciation.
Example of a cash generating business – Amazon
The cash flow numbers below show that Amazon increased its cash flow and free cash flow significantly over the last 10 years. Amazon increased its share count a bit, probably to finance the large investments for growth. Book value per share (equity value) increases as the company is able to grow its assets compared to the liabilities and retains earnings. It looks like Amazon is spending its CAPEX well and is able to increase the cash flow basically each year.
The EBITDA from the income statement of the last 5 years shows higher numbers than the Free Cash Flow. Logically, as Amazon invests a lot to grow and this is seen in the CAPEX spending.
What drives Amazon’s Free Cash Flow?
Jeff Bezos points out in the 2004 annual report that Amazon’s free cash flow is driven mostly by “increasing operating profit dollars and efficiently managing both working capital and capital expenditures”. Customer experience is important to grow the sales and Amazon monitors its costs closely. Quick inventory turnover and getting paid first and then paying suppliers later, leads to good free cash flow. Amazon needs low inventories ($480 million to generate $7 billion of sales) and good margins. Hence, Amazon can generate strong returns on capital with relative low debt.
Example of an unstable business – Nokia
Nokia is a company in the communications equipment sector. Nokia was in the news due to the dividend suspension and disappointing earnings. Nokia is a company that has ongoing CAPEX requirements and hence needs to generate enough money in order to have a positive free cash flow.
A quick cash flow analysis of the last 10 years of Nokia shows:
- Outstanding shares increased from 3,721 million to 5,597 million (meaning less earnings per share due to dilution and the need for raising money through placement of extra shares. Good businesses generally show the ability to buy back shares due to the strong cash flow)
- Book value (equity value) per share dropped
- Operational cash flow decreased, capital expenditures quite stable
- Decreasing cash flow and stable CAPEX resulted in low and negative free cash flow
An investor who would just concentrate on EBITDA would be deceived as can be seen below. The EBITDA on the income statement show positive numbers! Compare this to the Free Cash Flow which was negative in 2020 TTM, 2019 and 2017. Clearly, EBITDA overstates the cash that Nokia produces for its shareholders.
Reflection on Nokia’s financials
The analysis above does not mean that the price of Nokia will not go up this year. Lack of consistency does however increase the risk of having a poor investment result. Nokia can still perform well if they return to a healthy free cash flow situation.
Just looking at the numbers does not tell us how Nokia is spending its money. But it clearly shows that we have to be careful and should take great caution when thinking about buying Nokia. Personally, I’d rather look at companies which show stable positive and up trending free cash flow patterns.
Don’t just evaluate a company on EBITDA
A good business is focusing on Free Cash Flow not EBITDA. As Warren Buffett mentions “depreciation is the inverse of float: you spend first and then record expense later”. It’s the worst kind of expense. His partner Charlie Munger (Vice president of Berkshire Hathaway) even calls EBITDA “bs-earnings“).
It’s staggering to see how many newspapers and reports still focus on EBITDA. As a general rule, you will find that most good companies like Coca-Cola and Apple have positive Free Cash Flows. Your investment will likely under-perform if the free cash flow generation of a company turns out to be flawed. This is also why Warren Buffett emphasizes Free Cash Flow for selecting great businesses.