FOOL ON THE HILL
An Investment Opinion
Companies in every industry use different measures. For example, AT&T (NYSE: T), the Father Time of telecommunications, reports operational earnings, operational cash earnings, operational EBITDA, EBITDA, EBIT, and operational EBIT. Good grief.
What are investors supposed to do with this alphabet soup? To keep today's story under 15,000 words, let's focus on EBITDA (earnings before interest, taxes, depreciation, and amortization), often called cash flow, since it's used so often.
Is EBITDA a valuable measure of cash flow, shenanigans to make unprofitable or marginally profitable companies look sharp, or something in between?
My take is that EBITDA is worth a look in some cases but should never be used as a valuation tool. I came to this brilliant conclusion after a reader chewed up a story I'd written on casino operator Harrah's Entertainment (NYSE: HET).
In this article, I said gaming company investors often focus on EBITDA as a way of glimpsing a firm's true earnings power before certain charges. This is the party line on EBITDA -- that capital intensive companies report EBITDA to give investors a feel for cash flow before debt payments, taxes, depreciation, and amortization charges reduce the income statement to ashes. Problem is, EBITDA leaves out so much that its usefulness is very limited.
Now, companies that report EBITDA aren't doing anything wrong. It's just that when an analyst advises valuing shares on an EBITDA or cash flow basis you better sharpen your pencil.
First we need an example of what EBITDA does, because it can be handy. Say you're six years old and want to open an Orangina stand, hoping Coca-Cola (NYSE: KO) will eventually figure out a way to buy your operation. You have no money so mom and dad front the capital equipment costs: $30 for oranges, cups, sugar, water, and signage (not signs, signage).
At the end of the day, mom and dad want to know how much money you made. They don't want a figure that's been adjusted for interest payments on the debt you owe them, taxes, and depreciation of the fixed assets -- at least I hope not. That's the idea behind EBITDA, to give investors a sense how much money a young or fast-growing company is generating before it shells it all out to creditors, Uncle Sam, etc.
Look at wireless firm Nextel (Nasdaq: NXTL), which is spending a fortune to build a global communications network. Last year it reported a net loss of $1.5 billion. This bottom-line figure doesn't tell investors anything about the money Nextel generated from business, so it also reported EBITDA of $698 million. That's somewhat useful when compared to the company's EBITDA loss of $99 million in 1998. Investors see the company is making fast progress -- that people are aggressively buying its services.
EBITDA is really like looking at profits after deducting the cost of goods sold, and sales, general, and administrative expenses.
The problem is twofold: First, EBITDA leaves out so many expenses that to think of it as a measure of profitability is a huge mistake. Second, it's way off base to think of EBITDA as cash flow, or even a proxy for cash flow, since it doesn't measure actual cash flowing into a company.
Specifically, EBITDA neglects the following considerations:
Since this story is getting really boring, let's pick one item -- capital expenditures -- and focus on that. These expenses are a critical, ongoing outlay for almost every company. AT&T reported $18.2 billion in 1999 EBITDA. Wow. That's a nice improvement from 1998 when it reported $13.4 billion in EBITDA. But this measure disregards the company's sky-high capital expenditures.
Last year alone AT&T spent $13.5 billion on capital equipment, and it will continue spending billions annually to upgrade and build out its networks. Expenditures such as this will always be a big part of the mix for AT&T, as it will for gaming, cable television, satellite communications, and many other companies in industries that like to focus on EBITDA.
Since capital expenditures aren't part of the EBITDA mix, it's worse than useless for investors to start basing a company's valuation upon it. See, that $18.2 billion isn't available to AT&T investors. The company will consume a big chunk of it to generate expected cash flows in the future. Investor and businessman Warren Buffett talks about cash flow and capital expenditures in detail at the end of his 1986 annual report. Buffett doesn't look at cash flow anyway, but strongly advises backing out capital spending costs for those who do.
EBITDA also falls short as a measure of cash flow, which makes it especially confusing since companies often use the terms interchangeably. EBITDA doesn't really measure cash flow at all since it neglects the balance sheet.
For example, Nextel reported $698 million in EBITDA last year. Does that mean $698 million in cash actually flowed through the company's coffers? No. Look at the company's cash flow statement and you'll see it reported $324 million in cash from operations after adjusting for accounts receivable, and other costs like inventory. There's a big difference between these two numbers -- and the lower of the two is what measures cash actually provided by operations.
Is there a better way to evaluate cash flow? Sure, just look at cash flow from operations. If you want to go a step further, look at free cash flow (FCF). In its simplest form, FCF is simply cash from operations minus capital expenditures. This has the advantage of capturing at least three items EBITDA leaves out: Receivables, inventory, and capital expenditures (property, plant and equipment).
It's not a cure-all since it omits the cost of debt. Also, many terrific companies are cash flow negative in their formative stages. Wal-Mart reported negative free cash flow for years while handily beating its cost of capital and building its retail empire. Focusing on FCF alone could lead investors to miss opportunities.
There isn't any silver bullet when it comes to examining profitability. Smart investing involves taking the time to get familiar with a company, its industry, and the way it reports earnings.
Have a great day.