In the fascinating world of financial analysis and corporate accounting, jargon abounds. This wealth of terminology, while beneficial in its precision, can often mask the economic realities beneath. When used thoughtfully and transparently, these financial metrics can provide insightful snapshots of a company’s performance. But, in the wrong hands, they can also serve as smoke screens, obscuring true economic indicators and leading investors astray. One particular term, EBITDA, has come under intense scrutiny from a titan of the investment world, none other than the Berkshire Hathaway vice chairman himself, Charlie Munger. This article delves into his sharp critique of EBITDA in his own words and provides an illuminating exploration of the potential pitfalls of alternative financial presentations from fundamental reality.
Warren Buffett and Charlie Munger on EBITDA
Below is a transcript from Warren Buffett and Charlie Munger speaking at the 2003 Berkshire Hathaway annual meeting.[1]
A question from the audience, “Good afternoon, gentlemen. Andy Marino, of Chapel Hill by way of Boston. You have argued against the use of alternate measures of profitability, such as Earnings Before Interest, Tax, Deprecation, and Amortization (EBITDA), as measures of business performance. At the same time, you have frequently cited the incompleteness of Generally Accepted Accounting Principles (GAAP) in reflecting economic reality for some businesses, implying that there are some necessary and proper adjustments beyond what you recently described in the annual report as the ‘folly of omitting depreciation.’
Could you elaborate on your thoughts on other pitfalls of alternative financial presentations? Is EBITDA, in your view, just too often used as a shorthand for cash flow? Or is the entire concept of recasting accounting data a suspect exercise? Which revisions might be appropriate, if any, and what might be viewed as red flags? And does it matter to you who is making those adjustments – analysts, investors for their own purposes, or company managements – in terms of how that information should be viewed?”
Warren Buffett replies, “Yeah, we regularly told you, for some years before the accounting change was made here a year or so ago, we told you should not count goodwill amortization, you know, it was required under GAAP. We obviously complied with GAAP, but we told you, every year virtually that I can remember, we said this is not really an economic expense and we ignore it in our own calculations of earnings. In terms of what we will pay for businesses, we don’t care whether there’s a goodwill item or not because it’s immaterial to economic reality.”
“So we have been quite willing, at Berkshire, to tell our own owners to ignore certain things, and if they disagreed with us, they could look at the GAAP figures, but we felt they were getting misled by looking at the amortization of intangibles. That doesn’t mean we think all intangibles are good, but we did feel that that was an arbitrary and a decision that didn’t make any sense at all.”
“We’ve felt the crazy pension assumptions have caused people to record phantom earnings in many cases. So we’re willing to tell you when we think there is data that is more important in economic analysis than GAAP figures, we’ll talk to you about it.”
“Not thinking of depreciation as an expense, though, strikes me as absolutely crazy. I can think of very few businesses where depreciation is not a real expense. Even on our gas pipelines, at some point, they’ll need repairs, but beyond that, at some point, they become obsolete. There won’t be gas there 200 years from now; we know that. So depreciation is real, and it’s the worst kind of expense. It’s reverse float, you lay out the money before you get revenue, and you are out cash with nothing coming in.”
“Any management that doesn’t regard depreciation as an expense is living in a dream world. But of course, they’re encouraged to do that by investment bankers who talk to them about EBITDA. Certain people have built fortunes on misleading investors by convincing them that EBITDA was a big deal. When we see companies that say, ‘Hey, we don’t pay any taxes because we don’t have any earnings for tax purposes and don’t count depreciation and all of that,’ in our view, many times, that’s coming very close to a flimflam game.”
“I get these people that show me they want to send me books with EBITDA, and I just tell them, ‘I’ll look at that figure when you tell me you’ll make all the capital expenditures. If I’m going to make the capital expenditures, there’s very few businesses where I think I can spend a whole lot less than depreciation year after year and maintain the economic strength of the business.’ So, I think EBITDA has been a term that has cost a lot of investors a lot of money.”
“You saw it in the telecom field. The idea that they were spending money so fast, they couldn’t have it coming in the door fast enough from investors, and then they pretended that depreciation was not a real expense. That’s nonsense. It couldn’t be worse, and a generation of investors were sort of brought up to believe in that.”
“We at Berkshire will spend more than our depreciation this year. We spent more than our depreciation last year. We spent more than our depreciation the year before that. Depreciation is a real expense, just as much as the expenditure for life. It’s not a non-cash expense; it’s a cash expense. You just spent it first. The cash is gone, and it’s a delayed recording of cash outflows. How anybody can turn that into something they use as a metric that talks about earnings is beyond me. Charlie?”
Munger replies, “I think you would understand any presentation using the word EBITDA if every time you saw that word, you just substituted the phrase ‘bull***t earnings.” [Applause]
“And the man who made it through the morning but never all day,” Buffett interjects.
Munger continues, “And the man who asked the question also says, ‘What remaining big accounting troubles exist?'”
“The real lollapaloozas are pension fund accounting and, to some extent, post-retirement medical liabilities. Those are horribly understated now in America, and they’re very big numbers.”
Buffett interjects, “I’ve looked at financial statements, and you’ve seen them too in the last few months, where companies are recording pension income in the hundreds of millions while at the same time being underfunded in their pension plan in the many billions. They just aren’t facing up to reality at all and they don’t want to because they don’t want to take the hit.”
“It’s the same mentality as stock option expenses. They’re paying people with stock options. We pay people with cash bonuses, and I suppose we might like it if we didn’t have to record cash bonuses as expenses. It’s a way we pay people, and you can say, ‘Well, why don’t you put it in the footnotes and leave it out of the income account?’ like they do with option expenses, which is a form of compensation too.”
“But the answer is that a bunch of people who cared very much about having their stocks float to unreasonable prices, at least in our view, found they could do it a lot easier if they didn’t count it compensation expenses. Why not put all expenses in footnotes? Just have an item there that says sales and then have the same figure for net profit, and then just have all the expenses in the footnotes. People with a straight face say, ‘Well, it’s in the footnotes, so everybody knows about it, and we don’t have to count it, put it in the income account.'”
“It’s amazing what people with high IQs will do to rationalize their own pocketbooks. And Charlie has another explanation for why there’s been this denial of the reality of expense option expense in terms of people’s ego getting involved with their own records. Do you want to elaborate on that, Charlie? Don’t name names.”
Munger responds, “No, I’m so tiresome on this subject, and I’ve been on it for so many decades. It’s such a rotten way to run a civilization to make the basic accounting wrong. It is very much like making the engineering wrong when you’re building a bridge. When I see reputable people making these perfectly ridiculous arguments to the effect that it’s unthinkable that options should be expensed because it’s too difficult to value, well, because it’s too difficult to value, or God knows what reason. And a lot of them are people you’d be glad to have marry your daughter.”
“Mainly because they’re rich,” adds Buffett.
“The truth of the matter is, they’re somewhere between crazy and crooked,” concludes Munger.
“Put him down as undecided,” concludes Buffett.
Key Takeaways
- Beware of the illusion of profitability painted by EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Its usage can often mask the actual financial health of a business and mislead investors.
- Depreciation should not be disregarded as a non-cash expense; it’s a real expense with a deferred cash effect, reflecting the inevitable aging and obsolescence of assets.
- A critical accounting issue today is the undervaluation of pension fund accounting and post-retirement medical liabilities. These can create false positives in financial health, leading to investors being misinformed.
- Stock options are a form of compensation and should be treated as such in financial reporting. The practice of excluding them from financial accounts can inflate earnings, leading to unrealistic stock valuations.
- Accountability and transparency in financial reporting should not be compromised for personal gains or to artificially inflate share prices.
Conclusion
Charlie Munger’s insights underscore the importance of clarity, honesty, and realism in financial reporting. His warning against the misuse of EBITDA, and his emphasis on treating depreciation and stock options as real expenses, serve as vital reminders to investors and business owners alike. Equally critical is his call for improved pension and post-retirement liabilities accounting to reflect an entity’s true financial health. It’s a wake-up call for all shareholders, urging them to resist the short-term allure and instead champion financial integrity and long-term economic reality.
