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Charlie Munger and Warren Buffett on EBITDA

As I mentioned last week, Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) have long had a skeptical streak in them. Historically, they have spoken out against what they perceived to be the excesses in the financial industry, particularly as they pertain to accounting, consulting and corporate governance. In a famous set of remarks delivered at the 2002 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder meeting, the duo made their feelings clear about a very commonly used accounting metric - Ebitda.

A handy convention - for corporate managers

Ebitda stands for earnings before interest, taxes, depreciation and amortization. Supposedly, it is a more accurate reflection of how well a company has performed over a given period because it doesn't "artificially" decrease reported income due to the amount of tax or interest paid, which may vary from company to company and not reflect the intrinsic strength of the business in question.

In reality, however, it is often misleading because it obscures the fact that all of these deductions are legitimate costs that shareholders should be aware of. Buffett said that he and Munger have very rarely been defrauded, and one of the main reasons for that is they don't make decisions based on Ebitda:

"The number of times we're going to buy into a company where people are talking about Ebitda is roughly zero. If we take all the people in the world who have talked about Ebitda and those who haven't, there'll be plenty more frauds in the first group....Taxes are a real expense. Anybody who tells you that making a lot of money before taxes is meaningful [is wrong]. You get depreciation by laying out money ahead of time - it's the worst type of expense. We look for float, where we get the money and then pay out later on. But depreciation occurs because you buy an asset first and then you get the deduction later on. And you start paying taxes when you start making money."

Buffett and Munger expressed amazement at how widespread the usage of Ebitda has become given its inherent limitations and suggested that the reason why it has become so popular is that it allows managers to dress up their financials and make them look better by pretending that expenses like taxes and interest shouldn't matter.

In a similar vein, a proposal has been floated for businesses to adopt Ebitdac - earnings before interest, taxes, depreciation, amortization and coronavirus - a metric that would essentially give corporate management a pass for what they consider to be a "once in a lifetime" pandemic. Now, while it might certainly seem tempting to write off these costs, they still represent real expenses that companies have to pay. What's more, doing so penalizes forward-thinking corporate teams that put in provisions to protect themselves against such shocks. Better to have the unvarnished truth than a reassuring fable.

Disclosure: The author owns no stocks mentioned.

Read more here:

  • The Value Investor's Handbook: The Importance of Cash Flow
  • Charlie Munger and Warren Buffett on the Problem With Earnings Projections
  • The Value Investor's Handbook: Warning Signs to Avoid, Part 2

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This article first appeared on GuruFocus.