“I think that, every time you saw the word EBITDA, you should substitute the word [“BS”] earnings. People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.” – Charlie Munger.
Takeaway: Be mindful of depreciation expense and be wary of using EBITDA to value capital intensive businesses.
Given that the prices for products generally rise over time due to inflation, the depreciation expense on the income statement is often understated relative to economic reality. Let’s examine why this is the case:
Let’s say you own Rubber Band Co. and built a state-of-the-art, super shiny rubber band factory for $1 million that is depreciated over 10 years, after which it is worthless. Therefore, your company has $100,000 of depreciation expense per year for years 1-10 ($1 million asset value / 10 years of depreciable life = $100,000/year).
Additionally, you live in a world with 4% inflation, but you can’t raise the prices of your company’s rubber bands to offset due to many competitors offering the same product (you have low pricing power).
Assume your company’s operating income (“EBIT”) is $50,000 every year after the $100,000 of depreciation expense. On your income statement, it looks like you have a nice little profitable business, making a very cool $50,000 per year of profit before taxes.
Some investors (and you) may look at your company then on an EBITDA basis – or Earnings Before Interest Taxes Depreciation and Amortization. They would take your $50,000 of EBIT and add back the $100,000 of depreciation expense (since they would say this is a non-cash expense). Your company is, therefore, a $150,000 EBITDA business, and the investment bankers would look at similar companies to yours and maybe value it at a multiple of 6-8x EBITDA. Your rubber band business is worth $900,000-$1 million! Wow, you think to yourself!
Sounds like a pretty good little business right? Not so fast.
Remember the 4% annual cost inflation? Well in year 10 your factory is run-down and it’s time for you to buy a new state of the art factory. Now the same factory that costs $1 million 10 years ago costs $1.48 million because metal is more expensive, shipping costs are higher, labor is costlier, etc.
If this factory is also going to last 10 years, then the annual depreciation expense is now $148,000 per year – up from the $100,000 per year you had in depreciation expense before.
So now what does your business look like? Well, now you have an additional $48,000 of depreciation expense in the next 10 years vs. the previous 10. So your new operating profit (EBIT) is actually just $2,000. Not such a great business anymore!
Your company is still generating $150,000 of EBITDA though. If you can find someone to buy your company now for 6-8x EBITDA, you should probably sell it. After all, you are only making $2,000 of operating profit before taxes. If you could get a $1 million bid from someone who does not understand accounting and accepts the EBITDA metric that the investment bankers say is “industry standard” for rubber band businesses, you should probably sell.
So remember, watch that depreciation expense and make sure you think about it, particularly when you are analyzing a business or starting a business that requires a lot of capital!