Rule Maker Portfolio Ignore EBITDA

Oftentimes the Wise and members of the financial media use the term "earnings before interest, taxes, depreciation, and amortization," or EBITDA, as a substitute for cash flow. Phil Weiss is not fond of this practice and in today's Rule Maker column he highlights some of the reasons that investors should measure cash flow by what's found on the Statement of Cash Flows and not by looking at EBITDA.

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By Phil Weiss (TMF Grape)
September 6, 2001

[This story was updated on Sept. 25, 2001 to take into consideration a Lucent spokesperson's argument that EBITDA isn't a cash flow measure the company uses when discussing its results.]

As both an investor and an accountant, there are certain things that I find troubling (if not offensive) about the financial information that companies present to the public these days. On a number of occasions, I've written about some of the abuses one can find when looking at earnings press releases, as well as quarterly (10-Q) and annual (10-K) SEC filings.

In my last column I discussed some of the reasons investors should be careful about what's presented in "pro forma" earnings. Today, I'm going to talk a little about another tool that companies like to use to influence investors to overlook the true performance of their business -- EBITDA (earnings before interest, taxes, depreciation, and amortization). Among the companies that have been discussed in this space as either current or former Rule Makers that have referred to EBITDA are America Online Time Warner (NYSE: AOL) and Lucent Technologies (NYSE: LU).

Frequently, I've heard or read that EBITDA can be used as a substitute for cash flow. But it's not a substitute. It's simply accounting earnings with some adjustments. Two of the four items that are excluded -- interest and taxes -- can and do cost a company cash. Worse yet, debt holders and the Internal Revenue Service both have higher claims on a company's cash than we do as investors.

Excluding depreciation without considering the cost of new or replacement equipment is also a mistake. Cash flow can only be derived from the statement of cash flows, and you may still have to make some adjustments to the operating cash flow you see there in order to gain an accurate representation of the cash flow that is traditionally used to determine a company's true value.

I recently read a report on EBITDA by Moody's Investor Services that discussed 10 crucial ways in which EBITDA is not indicative of cash flow. I'd like to spend a little time discussing some of the most significant among these to us as investors:

  • EBITDA ignores changes in working capital and their impact on cash flow;
  • EBITDA fails to consider the amount of capital that companies must reinvest in their business; and
  • EBITDA can easily be manipulated through aggressive accounting policies related to revenue and expense recognition.

Working capital changes
EBITDA gives no consideration to a company's ability to generate cash from its operations. Earnings do not represent cash that the company has collected; they merely reflect the difference between revenues and expenses. Rule Maker investors have three tools at their disposal to measure a company's working capital management: Flow Ratio, Cash King Margin, and cash conversion cycle.

Since its merger with Time Warner, AOL has joined the list of companies that try to sway investors to use EBITDA rather than operating cash flow as a measure of performance. A look at its most recent Statement of Cash Flows shows that "Changes in operating assets and liabilities, net of acquisitions" were -$2.4 billion for the six months ended June 30. The result is that while AOL's EBITDA for this period was $3.9 billion, its cash provided by operations was $2.3 billion and its free cash flow was only $0.4 billion. At least AOL presented the free cash flow figure in its earnings press release.

Capital expenditures
EBITDA fails to recognize the capital expenditures that are taken into account when we calculate free cash flow. Recently I was shocked when I read in The Wall Street Journal that Lucent's management mentioned it would have positive EBITDA by the end of its March 31 quarter. It wasn't so much that I doubted what management stated (though that is a possibility), but that the metric is irrelevant for Lucent investors. Lucent had capital expenditures of $1.1 billion in the first two quarters of this year.

A spokesperson for Lucent stressed that the company doesn't focus, or encourage investors to focus, on EBITDA. As part of its recent debt covenants (agreements the company has with its lenders) the company has agreed to maintain certain levels of EBITDA relative to debt, but other than this, EBITDA isn't a cash flow measure the company uses when discussing its results.

The rationale behind excluding depreciation from EBITDA is that the funds generated by non-cash charges for depreciation are not needed to fund ordinary capital expenditures. Lucent's capital expenditures are too significant for that to be the case. Unless you believe that Lucent can fund its capital expenditures via excess cash balances (a look at its balance sheet calls that into question), then this figure should be deducted from EBITDA in calculating cash flow.

Accounting policies
The most significant way by which companies can affect the quality of accounting earnings is through their revenue recognition policy. Since EBITDA doesn't take into consideration the amount of cash the company collects, accounting policies are essentially irrelevant.

Another way that I've recently seen companies try to manipulate earnings is through the announcement -- by companies like Sun Microsystems (Nasdaq: SUNW) and Hewlett Packard (NYSE: HWP) -- that they were requiring employees to use a certain amount of vacation time. While this action does have an earnings benefit, it has absolutely zero impact from a cash flow perspective.

Companies accrue vacation time. These accruals result in a current liability on the balance sheet and an expense on the income statement. When employees use their vacation time, the liability on the balance sheet goes away, but there's no additional expense since the expense was charged at the time of the accrual. The result is a benefit in terms of earnings per share. This benefit is also reflected in EBITDA.

BUT, as noted above, EBITDA doesn't take changes into working capital into consideration. Accrued vacation time is a balance sheet liability that is part of working capital. When a company pays its vacationing employee, it does expend cash -- this is a perfect example of why decreases in liabilities on the balance sheet represent uses of working capital.

The bottom line is that while EBITDA may be useful in terms of evaluating firms in the same industry with widely different capital structures, tax rates and depreciation policies, it should not be used as a proxy for cash flow. If you want to determine a company's cash flow, or more importantly, its free cash flow, you should head over to the Statement of Cash Flows and work with the numbers you can find there.

Until next time, be Foolish.

Phil

Phil Weiss and his family reside in northwestern New Jersey. Seeing his 10-month old son's appetite has convinced Phil and his wife that they now have three reasons to invest -- saving for their children's education, saving for retirement, and making sure there's enough food. At the time of publication Phil owned shares of America Online. The Motley Fool is investors writing for investors.


 

Rule Maker Portfolio


9/6/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AXPAMER EXPRESS(1.45)(3.95%)35.28
CSCOCISCO SYSTEMS(0.48)(3.23%)14.40
INTCINTEL CORP(1.37)(4.99%)26.10
JNJJOHNSON & JOHNSON0.701.24%56.94
KOCOCA-COLA CO(0.94)(1.86%)49.51
MSFTMICROSOFT CORP(1.72)(2.98%)56.02
NOKNOKIA CORP ADS(0.90)(6.50%)12.95
PFEPFIZER, INC(0.89)(2.26%)38.45
SGPSCHERING-PLOUGH(2.11)(5.29%)37.74
TROWT.ROWE PRICE GRP INC(1.22)(3.24%)36.47
YHOOYAHOO INC0.464.32%11.10

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(1/6/1998)
Rule Maker(3.26%)(4.74%)(4.74%)(35.41%)(32.50%)
Comparable S&P 500n/an/an/an/a(0.10%)
S&P 500(2.24%)(2.40%)(2.40%)(16.20%)13.24%
S&P 500 (DA)(2.21%)(2.36%)(2.36%)(15.99%)15.01%
NASDAQ(3.03%)(5.53%)(5.53%)(30.96%)7.00%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (1/6/1998)
Rule Maker(14.01%)
vs. S&P 5000.27%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
2/3/9866PFE27.4338.4540.16%
4/3/0110JNJ43.6556.9430.45%
2/3/9859MSFT49.3556.0213.51%
2/3/9875TROW34.1236.476.89%
5/26/9879AXP36.4735.28(3.25%)
2/13/98147INTC27.4426.10(4.87%)
8/21/9844SGP47.9937.74(21.36%)
2/27/9827KO69.1149.51(28.36%)
6/23/98182CSCO24.7214.40(41.41%)
2/15/00132NOK40.2112.95(67.79%)
2/17/99106YHOO57.6011.10(80.73%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
2/3/9866PFE$1,810.57$2,537.70$727.13
2/3/9859MSFT$2,911.79$3,305.18$393.39
2/3/9875TROW$2,559.06$2,735.25$176.19
4/3/0110JNJ$436.50$569.40$132.90
5/26/9879AXP$2,880.87$2,787.12($93.75)
2/13/98147INTC$4,033.23$3,836.70($196.53)
8/21/9844SGP$2,111.70$1,660.56($451.14)
2/27/9827KO$1,865.89$1,336.77($529.12)
6/23/98182CSCO$4,498.75$2,620.80($1,874.92)
2/15/00132NOK$5,307.79$1,709.40($3,598.39)
2/17/99106YHOO$6,105.72$1,176.60($4,929.12)
 
Cash: 
Total: 
$548.21
$24,823.69
 


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.