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Warren Buffett: Beware of Businesses Trumpeting Ebitda

- By Stepan Lavrouk

There are many reasons a value investor may want to avoid a company. Perhaps the asking price is too high relative to its intrinsic value. Perhaps it lies outside their circle of competence. But these are all problems with legitimate companies. What about companies that engage in creative accounting, or outright fraud? How does one avoid these traps? In his 2002 letter to shareholders of Berkshire Hathaway (BRK-A)(BRK-B), Warren Buffett (Trades, Portfolio) detailed three warning signs you should pay attention to.

Beware of creative accounting

"Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen."

This is a pretty basic idea, but a quite interesting one nonetheless. If a company is not even bothered to do its basic bookkeeping properly, where else might it be cutting corners? Buffett considers such practices indicative of deeper issues.

He has also been vocal on the limitations of Ebitda as a financial metric. Truth be told, it always seemed strange to me that some businesses publicize these adjusted earnings, so as a student I was happy to learn that Buffett has similar misgivings on the issue:

"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.

Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"

One wonders what Buffett thinks of WeWork's " community-adjusted Eb itda ." He is likely bemused at the lengths some people will go to distort their financials.

Be on the lookout for needless complexity

The second signal that you will want to look out for is unnecessary complexity in accounting. Reading statements is not exactly the most exciting way to spend an afternoon, and there is a certain amount of specialist terminology that you need to know to really understand them, but at the end of the day, accounting should be fairly simple. Money comes in, and money comes out. It shouldn't be needlessly complex, and if it is that is usually a bad sign:

"Unintelligible footnotes usually indicate untrustworthy management. If you can't understand a footnote or other managerial explanation, it's usually because the CEO doesn't want you to. Enron's descriptions of certain transactions still baffle me."

A management team with nothing to hide shouldn't feel the need to obfuscate its public disclosures.

Earnings projections can spell trouble

Finally, you should look out for overly optimistic projections that assume steady growth:

"Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers).

Charlie and I not only don't know today what our businesses will earn next year - we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future - and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers."

The desire for certainty and regularity is a natural human urge, so it is understandable that investors want management to reassure them with promises of gradual earnings growth. Most people are uncomfortable with discontinuities and down periods, even if all the empirical evidence from financial history tells us that these will sometimes occur. But management also has a fiduciary duty to represent the situation as it actually is, and not give into these pressures. In the long run, that will serve investors better than reassuring fables.

Disclosure: The author owns no stocks mentioned.

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