Tag Archives: EBITDA

Earnings Lies & Why Munger Says “EBITDA is Bull S***”

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

3 Things: “R” Probabilities, Middle-Class, Bear Market Over

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Recession Probabilities Rise

As I penned earlier this week:

“Speaking of weather, last year, the BEA adjusted the ‘seasonal adjustment’ factors to compensate for the cold winter weather over the last couple of years that suppressed first quarter economic growth rates. (The irony here is that they adjusted adjustments for cold weather that generally occurs during winter.) 

However, the problem with ‘tinkering’ with the numbers comes when you have an exceptionally warm winter. The new adjustment factors, which boosted Q1 economic growth during the last two years will now create a large over-estimation of activity for the first quarter of this year. This anomaly will boost the ‘bullish hope’ as  the onset of a recession is delayed until those over-estimations are revised away over the course of the next year. ” 

The reason I reiterate this point is due to a recent research note from Wells Fargo discussing the increased risk of a domestic recession. To wit:

“One possible way to summarize the results from all these models is to calculate the average of these probabilities and then examine historical performance of the average probability. The current average probability is 37.3 percent and this method predicted all recessions successfully since 1980 without producing any false positives (Figure 11). Different models utilize different predictors to capture the state of different sectors of the economy and therefore an average probability may reflect the average risk posed by these sectors.

At present, we are not calling for a recession within the next six months. However, given that the recession probabilities based on our official model and average of all models are somewhat elevated, it is not wise to dismiss recession risk.”

Recession-Probit-WellsFargo-030316-2

The combined Probit Model based on the entire series of indicators utilized by Wells Fargo, (which includes LEI, VIX, Yield Spread, Stock Prices, Commodities and more) also confirms the same recessionary stresses shown in the Economic Output Composite Index (EOCI).

EOCI-Index-LEI-030216
(The EOCI Index is a composite of the Chicago Fed National Activity Index, ISM Composite, Several Fed Regional Surveys, Chicago PMI, LEI, and the NFIB Small Business Survey.)

As shown, the economy is currently operating at levels that have normally been associated with recessionary environments. The only thing that has kept the economy from registering a recession in the past has been the interventions by the Fed that have led to a “forward-pull” of future economic activity. (Beginnings and endings of QE programs noted by gold squares)

While there are many mainstream economists insisting that the U.S. economy is nowhere near recession, considering much of the current data will be negatively revised in the quarters ahead will likely prove those views wrong.

With economic data having remained extremely weak in recent months, it will NOT be surprising to see a short-term pickup in economic activity as a restocking cycle once again leads to temporary bounce. However, as we have repeatedly seen since 2009, those bounces in activity have been transient at best. Without monetary support from the Federal Reserve to once again “drag forward future consumption,” the risk of sliding into recession becomes a very real possibility. 

The Decline Of The Middle Class

I have often written about the broad decline in the financial conditions of the middle class.

There is a financial crisis on the horizon. It is a crisis that all the Central Bank interventions in the world cannot cure.

No, I am not talking about the next Lehman event or the next financial market meltdown. Although something akin to both will happen in the not-so-distant future. It is the lack of financial stability of the current, and next, generation that will shape the American landscape in the future.

The nonprofit National Institute on Retirement Security released a study in March stating that nearly 40 million working-age households (about 45 percent of the U.S. total) have no retirement savings at all. And those that do have retirement savings don’t have enough. As I discussed recently, the Federal Reserve’s 2013 Survey of consumer finances found that the mean holdings for families with retirement accounts was only $201,000.”

Fed-Survey-2013-NetWorthbyAge-091014

Such levels of financial “savings” are hardly sufficient to support individuals through retirement. This is particularly the case as life expectancy has grown, and healthcare costs skyrocket in the latter stages of life due historically high levels of obesity and poor physical health. The lack of financial stability will ultimately shift almost entirely onto the already grossly underfunded welfare system.”

Just recently the Pew Research Center confirmed the same:

After more than four decades of serving as the nation’s economic majority, the American middle class is now matched in number by those in the economic tiers above and below it. In early 2015, 120.8 million adults were in middle-income households, compared with 121.3 million in lower- and upper-income households combined, a demographic shift that could signal a tipping point, according to a new Pew Research Center analysis of government data.

In at least one sense, the shift represents economic progress: While the share of U.S. adults living in both upper- and lower-income households rose alongside the declining share in the middle from 1971 to 2015, the share in the upper-income tier grew more.”

Pew-MiddleClass-Chart-030216

“Over the same period, however, the nation’s aggregate household income has substantially shifted from middle-income to upper-income households, driven by the growing size of the upper-income tier and more rapid gains in income at the top.Fully 49% of U.S. aggregate income went to upper-income households in 2014, up from 29% in 1970. The share accruing to middle-income households was 43% in 2014, down substantially from 62% in 1970.

And middle-income Americans have fallen further behind financially in the new century. In 2014, the median income of these households was 4% less than in 2000. Moreover, because of the housing market crisis and the Great Recession of 2007-09, their median wealth (assets minus debts) fell by 28% from 2001 to 2013.”

Importantly, this is why economic growth remains weak. While the Federal Reserve was focused on boosting asset prices for the wealthy, they forgot to create an economic environment that was conducive to increasing the consumptive power of the middle-class and their near 70% participation in economic growth.

Oops.

The True Definition Of A Bear Market

The sharp rally over the last couple weeks, which has been primarily driven by massive short-covering, has brought the “bulls” out once again declaring the recent “bearish decline” over. However, is such really the case, or is this yet another of the many rallies we have seen as of late that ultimately fail?

In order to answer that question, we must first define what a bear market really is. The currently accepted definition of a “correction” is a 10% decline and an official “bear market” begins with a 20% fall in the market. However, both of these definitions are not accurate we have seen both such events occur during longer-term market trends.

For investors, the difference between a “bull” and a “bear” market, regardless of the short-term fluctuation in prices, is whether the overall “trend” in prices is rising or falling. When the “trend” is positive, speculating in the financial markets is advantageous as the “rising tide” increases the value of portfolios. Conversely, when the overall trend is “negative,” speculating in the financial markets has a generally negative result.

(We are not investors, we are speculators. Warren Buffett is an investor. When he invests in a company he can control its destiny by appointing operating managers, defining directives, etc. YOU are a speculator placing bets with your “savings” on ethereal pieces of paper that you “hope” will rise in price over time. Understanding this point is important.)

The utilization of a simple moving average is one way the overall trend of the market can be determined. A moving average is an “average” of prices over a given period of time. In order for there to be an average price, prices must have traded at two points of extreme over the sample period. If prices are generally “trending” higher, the average will be positively sloped as each new low and high point is greater than the last. The opposite is true when prices are generally “trending” lower.

Overall bullish and bearish trends are revealed when looking at longer-term price trends of the market. The chart below is an example.

SP500-MarketUpdate-030316

(Note: This is a WEEKLY price chart to smooth out short-term price volatility. We are using an 80-week moving average and a 52-week RSI for this example.)

During “Bull Markets” – prices tend to remain above an “upward” or “positively” sloping moving average. Also, the relative strength index (RSI) stays above 50 during that period.

During “Bear Markets” – prices tend to remain below a “downward” or “negatively” sloping moving average. RSI also remains below 50 during this period confirming a more “risk adverse” environment.

Currently, all indications currently suggest the markets are in the early stages of entering into a confirmed “bear market” as the longer term moving average is turning from a positive to a negative slope and RSI has fallen below 50.

Yes, things could change very quickly with the intervention of Central Bank action. The same was seen during the summer and fall of 2011 as then Fed Chairman Ben Bernanke quickly acted to stave off a more serious market decline. However, with the Fed more focused on “tightening” monetary policy currently, such a salvation seems to be a low probability event.

The value in changing your definition of a “bear market” is by waiting to lose 20% of your portfolio before acting, it takes a 25% subsequent rise in the market to get back to even. That is “time” lost that you can never regain.

As stated earlier this week, the rules for managing your portfolio are relatively simple:

  1. In rising market trends – buy dips.
  2. In declining market trends – sell rallies.

Despite the ongoing “hopes” of the always bullish media, the recent rally has not changed the slope, or scope, of current market dynamics. The current “bear market” is not over just yet.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Earnings Lies, Profits Slide, EBITDA Is BullS***

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

According to analysts at Bank of America Merrill Lynch, the percentage of companies reporting adjusted earnings has increased sharply over the past 18 months or so. Today, almost 90% of companies now report earnings on an adjusted basis.

Adjusted-Earnings-022516

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back. Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

As BofAML states:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant and since 2013, the number has been on a steady rise.

We are increasingly concerned with this trend, as on an unadjusted basis non-commodity earnings growth has been negative 2 of the last 4 quarters, representing the worst 4 quarter average earnings growth in a non-recessionary period since late 2000.”

This accounting manipulation to win the “beat the earnings” game each quarter is important to corporate executives whose major source of wealth is stock-based compensation. As confirmed in a WSJ article:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. 

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings.

The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

Why is this important? Because, while manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings manipulations, share-buybacks, etc. reach their effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues. That point has likely been reached.

From the WSJ:

There’s a big difference between companies’ advertised performance in 2015 and how they actually did.

How big? With most calendar-year results now in, FactSet estimates companies in the S&P 500 earned 0.4% more per share in 2015 than the year before. That marks the weakest growth since 2009. But this is based on so-called pro forma figures, results provided by companies that exclude certain items such as restructuring charges or stock-based compensation.

Look to results reported under generally accepted accounting principles (GAAP) and S&P earnings per share fell by 12.7%, according to S&P Dow Jones Indices. That is the sharpest decline since the financial crisis year of 2008. Plus, the reported earnings were 25% lower than the pro forma figures—the widest difference since 2008 when companies took a record amount of charges.

The implication: Even after a brutal start to 2016, stocks may still be more expensive than they seem. Even worse, investors may be paying for earnings and growth that aren’t anywhere near what they think. The result could be that share prices have even further to fall before they entice true value investors.

The difference shows up starkly when looking at price/earnings ratios. On a pro forma basis, the S&P trades at less than 17 times 2015 earnings. But that shoots up to over 21 times under GAAP.

S&P-500-Earnings-WorseThanRealized-022416

History is pretty clear. As long as earnings are deteriorating, you don’t want to be invested in stocks.

Fantasy Vs. Reality

What is most interesting, is that despite the ongoing earnings recession, Wall Street firms continue to predict an onward and upward push of profitability into the foreseeable future. As shown in the estimates below from Goldman Sachs, there is NO consideration for the impact of economic recession over the next several years.

GS-Profits-SP500-Targets-022316

Of course, this was the same prediction made in 1999 and in 2006 until the eventual and inevitable “reversion to the mean” occurred.

Eric Parnell recently penned an excellent piece in this regard entitled “Fantasy vs. Reality:”

The perpetual optimism of the corporate earnings forecast is remarkable. And while its well understood that things almost never turn out as good as we might anticipate, it is notable how widely divergent these earnings forecasts are from the actual outcomes that ultimately come to pass. Beware the analysis pinning its conclusions on the forward price-to-earnings ratio on the S&P 500 Index or any of its constituents for that matter, for it may lead to conclusions that are ultimately built on sand.

Clearly, relying on corporate earnings forecasts for the basis of investment decision making should be done at an investors own risk. Forecasts start out as wildly optimistic, with greater hopes the longer the time horizon. Which leads to a final point worth mentioning. Standard & Poor’s recently released a first look at the earnings forecasts for 2017. And if past experience is any guide, it may be indicating trouble on the horizon for the coming year. For instead of the robust +20% earnings forecasts throughout 2017, we instead see a notable fade as the year progresses. Perhaps these forecasts will improve with the passage of time.

But if forecasters are this unenthusiastic about a point that is so far away in the future, what will the reality look like once we finally arrive?”

Corporate-Profits-Growth-2017-022416

Unfortunately, considering that historically analysts future forecasts are 33% higher on average than reality turns out to be, the case for a deeper “bear market” is gaining traction.

EBITDA Is BullS***

I have written in the past about the fallacy of using EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) due to the ability to fudge/manipulate the number. To wit:

Cooking-The-Books

“As shown in the table, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures. For fundamental investors this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.”

Ramy Elitzur, via The Account Art Of War, recently expounded on the problems of using EBITDA.

“Being a CPA and having an MBA, in my arrogance I thought that I am well beyond such materials. I stood corrected, whatever I thought I knew about accounting was turned on its head. One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

  1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading, as I illustrated above, to a false sense of liquidity.
  2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
  3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
  4. EBITDA just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As discussed above, the tricks to manipulate earnings are well-known which inflates the results to a significant degree making an investment appear “cheaper” than it actually is.

As Charlie Munger once said:

“I think that every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In