“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a new vocabulary…EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash generating ability of a business…”
- William Thorndike, “The Outsiders”
“I think that, every time you (see) the word EBITDA you should substitute the word bullshit earnings.”
- Charlie Munger
The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
A company’s EPS (which is just net income divided by shares outstanding) is often referred to as its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom line. This may sound like a quibble on my part. But, let’s stop and think about it a second.
If EBITDA is “bullshit earnings” because it is earnings before:
- Depreciation and
Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:
- unrealized gains and losses on available for sale securities
- unrealized currency gains and losses
- and changes in the pension plan?
I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only numbers reported to shareholders.
Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There is an entire income statement full of figures shown to investors each year.
Profit figures further down the income statement are always more complete – and therefore less “bullshit” – than profit figures further up the income statement.
- EBITDA is always less bullshit than gross profit.
- EBIT is always less bullshit than EBITDA.
- EPS is always less bullshit than EBIT.
- And comprehensive income is always less bullshit than EPS.
Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net income per share). Buffett wants to report the least bullshit – most complete – profit figure possible.
So, if profit figures further down the income statement are always more complete figures, why would an investor ever focus on a profit figure higher up the income statement (like EBITDA) instead of a profit figure further down the income statement (like net income)?
At most companies, items further up the income statement are more stable than items further down the income statement.
I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The measure of stability I am going to use is the “coefficient of variation” which is sometimes also called the “relative standard deviation” of each series. It’s just a measure of how scattered a group of points are around the central tendency of that group. Imagine one of those human shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest would rate a 0.01. A bullet hole that winged the shoulder might rate a 0.50. The bullet holes here are specific annual results.
Let’s look at the variation in Grainger’s margins from 1991 through 2014:
- Gross margin: 0.10
- EBITDA margin: 0.16
- EBIT margin: 0.19
What do these numbers tell us?
Well, the annual bullet holes for EBIT are 19% more scattered (0.19/0.16 = 1.19) than the bullet holes for EBITDA. The only difference between EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is D&A (Depreciation and Amortization). What we are seeing here is a meaningful amount of year-to-year “scatter” caused simply by accounting entries for depreciation and amortization.
As long-term investors, do we really want to focus on that kind of scatter in the year-to-year results? Is the underlying (25-year) trend in Grainger’s EBITDA and EBIT really any different? If not, should we even look at depreciation and amortization?
I don’t think so. I think including D&A in Grainger’s year-to-year results just makes the long-term trend in economic earnings more “noisy” and less clear.
And that “noise” I’m complaining about comes just from the difference between EBITDA and EBIT. What if we move even further up the income statement?
Well, operating profit (EBIT) varied 90% more (0.19/0.10 = 1.9) than gross profit. So what? Who cares about gross profit?
In fact, at Grainger, I believe it is more useful to focus on the trend in gross profit than the trend in operating profit (EBIT). And there’s research to back me up on this.
“Gross profits is the cleanest accounting measure of true economic profitability.”
- Robert Novy-Marx
A professor at the University of Rochester, Robert Novy-Marx, wrote a paper that showed investing in companies with persistently high profitability is a winning investment strategy.
To prove his point, Novy-Marx didn’t use return on equity. Return on equity uses net income in its numerator. Novy-Marx used gross profitability. That measures puts assets in the denominator and gross profits (the profit line furthest up the income statement) in the numerator.
Here’s the reason Novy-Marx gave for using gross profits:
“Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more polluted profitability measures become, and the less related they are to true economic profitability. For example, a firm that has both lower production costs and higher sales than its competitors is unambiguously more profitable. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales though aggressive advertising, or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income below that of its less profitable competitors. Similarly, if the firm spends on research and development to further increase its production advantage, or invests in organizational capital that will help it maintain its competitive advantage, these actions result in lower current earnings.”
I’m sure the 8 CEOs profiled in William Thorndike’s “The Outsiders” would agree. All of these CEOs focused on compounding the per share intrinsic value of their stock without regard to how much of that added value they’d actually be able to report in earnings per share.
John Malone: Why EBITDA Matters
Let’s start with John Malone:
“Malone pioneered the active use of debt in the cable industry. He believed financial leverage had two important attributes: it magnified financial returns, and it helped shelter TCI’s cash flow from taxes through the deductibility of interest payments. Malone targeted a ratio of five times debt to EBITDA and maintained it throughout most of the 1980s and 1990s.”
- William Thorndike, “The Outsiders”
Here we see an “outsider” type CEO focusing on a profit line – EBITDA – further up the income statement, because of two things he believed he could control:
- How much his company pays in taxes and
- How much shareholder money he has to use per dollar of corporate assets.
In other words, Malone believed that if he achieved the same EBITDA divided by assets as the rest of the cable industry – his stock would outperform their stocks, because:
- TCI would pay less of its EBITDA out in taxes and
- TCI’s shareholders would control more assets per dollar of their own equity
In this way, Malone wouldn’t have to change the basic, inherent economics of the cable business – EBITDA/Assets – to get a better compound result for his stock than the rest of the industry.
This story provides us with a warning. It would be fairly safe to assume that the rate of EBITDA/Assets at TCI would be the same regardless of who controlled capital allocation at the company. It would not be safe to assume that anything further down the income statement than the EBITDA line would stay the same regardless of who was in charge. The same cable system in someone else’s hands – not Malone’s – might earn the same EBITDA/Assets, but it would definitely earn a lower return on equity (Net Income / Equity). TCI as a corporation would be more financially efficient with Malone than without Malone even if the inherent efficiency of the company’s cable assets (EBITDA/Assets) was something Malone could never change.
This can be stated as a general rule:
The further up the income statement you go, the more you learn about the inherent economics of a business. The further down the income statement you go, the more you learn about the people who run the business.
With that in mind, let’s take a look at Tom Murphy and Capital Cities.
Tom Murphy: Why Operating Expenses are Optional
“The core economic rationale for the deal was Murphy’s conviction that he could improve the margins for ABC’s TV stations from the low thirties up to Capital Cities’ industry-leading levels (50-plus percent)…the margin gap was closed in just two years.”
- William Thorndike, “The Outsiders”
This is the same reason 3G is willing to bid such high multiples of earnings and EBITDA for the companies it takes over. 3G doesn’t care what the current earnings and EBITDA of a company are. 3G only cares what the current sales level is. There isn’t much 3G can do to grow unit volumes in beer or ketchup or cheese. There is a lot 3G can do to cut costs at headquarters, in the factories, and on the delivery routes.
“Murphy and Burke realized early on that while you couldn’t control your revenues at a TV station, you could control your costs.”
- William Thorndike, “The Outsiders”
The same is true at food and beverage companies. The market power of Budweiser and Heinz and Kraft is what it is regardless of who controls those brands. But, the operating expenses at Budweiser and Heinz and Kraft are lower under 3G’s control than they would be under anyone else.
So, which earnings measure is the right measure?
- Is comprehensive income a better measure than net income?
- Is EBITDA really “bullshit earnings” the way Charlie Munger says it is?
- And: does gross profit tell you more about a business’s competitive position than net profit?
There is no “right” measure of earnings for all purposes. To get the full record of what exactly the company you own stock in earned this year – comprehensive income is the best measure. To know the “pure cash generating ability of a business” – EBITDA is the best measure.
And to measure the thing I care most about…
Market Power and Gross Profits
No line on an income statement can tell you what a business’s market power is. But, if there was one such line – it would be gross profits.
If you’ve read my mental model post, you know I define market power as:
“… the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”
Market power generates gross profits. Market power doesn’t necessarily generate net profits. A business with market power can be managed efficiently or inefficiently below the gross profit line. As an example, Capital Cities’ local TV stations and ABC’s local TV stations had exactly the same market power pre-merger. All of those stations were affiliates of a major network, were part of a local oligopoly (with an ABC, NBC, and CBS affiliate controlling most of the local TV ad market), and negotiated with the same advertisers when selling their air time. ABC’s local TV stations had an EBITDA margin around 30%. Capital Cities’ local TV stations had an EBITDA margin around 50%. After Capital Cities merged with ABC, the ABC stations went from a 30% EBITDA margin to a 50% EBITDA margin.
Because those costs were all internal to the business. External prices and costs are determined largely by market power (over customers and suppliers respectively). While internal expenses are determined largely by managerial will.
Revenue is a much higher line on the income statement than EBITDA. And yet, revenue was the right line to use in valuing ABC if you knew Capital Cities was going to buy ABC.
That’s the key to knowing which earnings measure to use. The inherent economics of a business are what matters to an acquirer who is willing to slash costs. For Capital Cities and 3G, the numbers that matter are revenue and gross profit. Reported earnings don’t matter in a takeover.
But, what about you?
You’re a passive, long-term investor. Which profit measure should you focus on?
As a long-term investor in a specific business in a specific industry – I think gross profitability (Gross Profits / Assets) matters most.
And as a long-term investor in a specific capital allocator running a specific corporation – I think EBITDA matters most.
The business’s long-term destiny is tied to its market power. The capital allocator’s long-term destiny is tied to the capital he gets to deploy.
I’ll leave you with 3 key takeaways:
- Gross profitability is the best indicator of market power
- Profit figures higher in the income statement tell you about the economics of the business; profit figures lower in the income statement tell you about the CEO’s skill
- There is no “right” measure of profitability. Learn to use them all.
Finally, when betting on lasting business quality – think in terms of gross profitability. And when betting on lasting managerial quality – think in terms of cash flow.
Everyone focuses on EPS. By moving up the income statement, you’ll be moving out of the herd.