In the 1986 shareholder letter Buffett delves into what he calls “owner earnings”, which is what he deems to be the correct metric to use for company valuation purposes. When Buffett went into owner earnings it was also a critique against what many deem to be a company’s “cash flow”. Although he does not specifically mention it in the 1986 shareholder letter, he has criticized the term elsewhere – EBITDA, a metric used by many people as a proxy for “cash flow, is an example of “cash flow” that is heavily flawed.
The primary reason cash flow metrics like EBITDA or net income plus depreciation and amortization (D&A) are not fully reflective of a company’s cash flow is because they leave out two recurring cash flow changes that most companies experience every year: capital expenditures and changes in working capital. In other words, EBITDA overstates a company’s cash flow by not taking a charge for CAPEX and working capital while the other common method of simply adding depreciation back to net income also is inaccurate – adding back depreciation without any adjustment for a recurring capital expenditure paints the false picture of a company that does not need to spend any CAPEX to maintain its competitive position or unit volume. It’s not a realistic picture. See the excerpt below from the 1986 shareholder letter:
So what is the best way to estimate (c) the “average annual amount of capitalized expenditures for plant and equipment”?
We can think of a couple of ways. Because D&A charges can fluctuate, one could take the average D&A over several years, with the average taken over more years if there are longer life assets on the company’s balance sheet. One could also take the average CAPEX from the cash flow statement and deduct this figure. The tricky thing with both methods is that part of the CAPEX will be maintenance CAPEX and part will be growth CAPEX.
Here is another excerpt where Buffett describes the flaw of EBITDA in the 2000 shareholder letter:
No the tooth fairy does not pay for CAPEX. We have to account for it to assess a company’s true earnings power.
There have been numerous warnings about EBITDA throughout the years in the shareholder letters. Here is an excerpt from the 2002 shareholder letter:
And more recently from the 2014 shareholder letter:
EBITDA is not a totally useless metric as a proxy for cash flow available to all stakeholders (i.e. debt holders, the government, equity holders, etc). We think it’s very valuable especially if it has been adjusted for non-recurring charges, particularly those of the non-cash variety. But Buffett is right, as depreciation is a real, ongoing expense – hence, having EBITDA minus ongoing, recurring CAPEX (EBITDA – CAPEX) paints a more accurate picture of a business as a going concern. Taking a multiple of EBITDA minus CAPEX is a way of valuing companies that must be considered.