Warren Buffet and EBITDA

I’ve been asked this question more than once. It goes like this: “Warren Buffet and Charlie Munger think EBITDA is bullsh*t… a direct quote from Charlie. So why do we use it to value businesses?”

Good question. I’d answer this way. Warren and Charlie have a few basic investing rules. One compares the “intrinsic value” of a business to its share price—and if it’s greater, the stock becomes a potential buy.

The intrinsic value of business is the present value of the future cash flow of the business, subject to refinements. The calculation requires a discount rate, which is the cost of capital associated with cashflow risk. And we need the term of the future earnings period. But let’s leave the calculation part aside

Here is the beef Warren and Charlie have with EBITDA. They don’t think EBITDA is the right earnings number for calculating intrinsic value. And they are right of course. They complain that depreciation is a real expense. Equipment has to be replaced. So EBITDA is a lousy metric for “earnings”… because it ignores wear and tear on fixed assets (i.e. ignores depreciation)… despite depreciation being a real economic expense.

But we don't use EBITDA that way, so that analysis doesn’t apply in the SMB universe. The valuation method that Warren and Charlie are referring to with intrinsic value… is the “income approach” which is based on future earnings.

In SMB-land we use the market approach which is based on historic earnings. It compares the historic earnings of a target company to the historic earnings of similar businesses that recently sold. And we conclude the right value for the target business… is the price those other businesses sold for?

In this case, EBITDA is the right metric to use for earnings. If we didn’t use EBITDA we would be in a weird situation where two virtually identical businesses would be valued differently based on the age of their fixed assets.

Oldco with fully depreciated assets would have higher earnings and a higher valuation (because the equipment carries no depreciation charge) than Newco who has newer updated equipment which still carries a depreciation charge.

Clearly that can’t be right. All other things being equal, Oldco wouldn’t be worth more than Newco because it has older fully depreciated equipment. By using EBITDA for earnings we remove that issue… along with the tax and amortization issue as well.

While Warren and Charlie have a great take on the problems with EBITDA being used to calculate intrinsic value… it serves a different purpose in SMB-land. So go right on using EBITDA multiples to value the business.

If you have a business buying question… deal specific or not… I would be happy to give it my best shot at answering.