Charlie Munger explains why he called a popular earnings measure 'horror squared'
During Berkshire Hathaway’s annual meeting on Saturday, a shareholder asked CEO Warren Buffett and his vice chairman, Charlie Munger, why they object to a popular indicator of a company’s financial performance known as EBITDA.
That stands for Earnings Before Interest Taxes Depreciation and Amortization, and it lets companies add expenses from interest, tax, depreciation, and amortization back onto net income. EBITDA has sparked controversy because companies can easily manipulate the number, as WorldCom famously did to hide $3.8 billion back in the early aughts. Buffett, in particular, has attacked EBITDA for not treating the depreciation of goods as “a real cost.”
Munger, who’s known for not mincing words, said the “horrors” of EBITDA have been understated as has the “disgusting nature of the people that brought that term into the valuation of business.”
He continued: “And now they use it in the business schools. Now, that is, that is horror squared. I mean, it’s bad enough that a bunch of thieves start using a term. But when it gets so common that the business schools copy it, that’s not a good result.”
After the meeting, Yahoo Finance’s Editor-in-Chief Andy Serwer asked Munger to elaborate on his disdain for EBITDA, a term that first became popular in the 1980s in the context of leveraged buyouts.
“The idea that depreciation doesn’t matter? … You have to replace the trucks all the time. It’s a real cost. As Warren says, it’s the worst cost, because you pay it way in advance, and get the benefit way later,” Munger told Serwer. “So it’s absolutely insane. And of course, it was a bunch of investment bankers that invented it to make their trade easier. And it’s disgusting.”
For his part, Buffett called EBITDA the opposite of float. That’s money that insurance companies get from premiums years before they pay out policies, and it’s played a major role in the success of Berkshire since it owns several insurance companies.
“You know, we love to talk about float. And float is where we get the money first, and we have the expense later,” Buffett said on Saturday. “Depreciation is where you spend the money first, you know, and then record the expense later. And it’s reverse float. And it’s not a good thing.”
This is not the first time Buffett has inveighed against EBITDA. In his 2013 shareholder letter, Buffett made a point to tell his investors that Berkshire doesn’t measure its earnings that way.
“Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well,” Buffett wrote. “When Wall Streeters tout EBITDA as a valuation guide, button your wallet.”
The rationale for those who do use EBITDA as a valuation guide is this: It can provide a look at earnings stripped of variable factors like taxes, depreciating goods, and capital expenditures (onetime purchases like land). Still, as Buffett and Munger both made clear, it’s clear that this measure gives companies wider latitude to mislead the public about their expenses.
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