Alphabet Dupe: Why Ebitda Falls Short Judging a company's prospects in this market is no small feat. Unfortunately, one popular accounting trick only makes it harder.
By Herb Greenberg

(FORTUNE Magazine) – Is Ebitda getting out of hand? I first raised the question two years ago in this very space, and guess what? You could (make that should) ask the same question today. The financial benchmark--which stands for earnings before interest, taxes, depreciation, and amortization--became famous in the 1980s when corporate raiders used it to try to justify staging overpriced buyouts.

Back then, at least, it was a small (and somewhat unsavory) band of financiers throwing the term around willy-nilly. Nowadays the device is used by all kinds of companies trying to make themselves look prettier than they really are. And it's a cinch for them to do: They simply make a bigger deal over Ebitda than actual earnings in their quarterly press releases, then include a small disclaimer in their SEC filings about how Ebitda is not part of Generally Accepted Accounting Principles. Some banks, without batting an eyelash, even let companies base their loan covenants on it.

In fact, the benchmark has become so overused by corporations (and so gullibly accepted by Wall Street) that Moody's analyst Pamela Stumpp recently penned a 24-page report probing what she calls the "critical failings" of Ebitda. She frets that the once arcane acronym is now used so interchangeably with cash flow--a more accurate measure of a company's financial health--that investors have started thinking they're the same thing. "Is the use of Ebitda," Stumpp asks in the report, "becoming too commonplace...and replacing thoughtful analysis?" Without a doubt, yes.

Not that it doesn't have legitimate purposes. Ebitda really is an accurate measure of cash flow--assuming you don't have to spend money on, say, buying big equipment or paying interest on debt. In that sense it can be useful for analyzing businesses like television and radio stations, whose equipment generally has a long life. (When was the last time you saw a new radio tower going up?)

The trouble is that Ebitda now gets widely used by companies whose assets have considerably shorter lives--sometimes less than three to five years. What's more, it's often used by companies already loaded down with debt. (They don't want you to look at the interest part of the equation.) "High-yield companies will come into rating agencies with memos to discuss their credit," Stumpp says, "and they'll use Ebitda as an approximate measure of cash flow."

Therein lies the heart of the debate, and what you might call Critical Failing No. 1: Ebitda isn't the same as cash flow. Quite simply, cash flow is what's left in the till after you account for all the cash coming in and all the cash going out during a given period. It represents the resources a company can actually use to keep itself out of trouble, and it can't be rigged to look better than it is. Ebitda is some multiple of cash flow, and if you're judging a company based on it, you'd better hope the company doesn't get into any trouble. You'd also better assume it won't need to spend money upgrading its equipment anytime soon.

For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its Ebitda performance, but that masks a big part of how the company operates--and spends its money. Premier argues that depreciation for big-ticket items like roller coasters should be ignored because rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50% of its Ebitda just to keep its rides and attractions current. Those expenses are not optional--let the rides get a little rusty, and ticket sales start to trail off. That means depreciation associated with the costs of maintaining rides (or buying new ones) should really be viewed as an everyday expense. It also means investors in those companies should have strong stomachs. Premier's CFO did not respond to requests for comment.

Failing No. 2: Ebitda can be a misleading measure of a company's access to cash and its ability to pay interest on its debt. "It creates the appearance of stronger interest coverage and lower financial leverage," Stumpp says. Take the funeral industry, where Ebitda has become the favored form of reporting financial performance. Much of the industry's income comes from the sale of so-called "pre-need" funerals (a wonderfully euphemistic industry term meaning you pay for the pomp surrounding your unfortunate circumstance up front--sometimes years in advance). Cash from some of those sales gets stashed in trust funds that can't be touched for years, until the buyer dies. Management can't use that money to bail the company out. Try telling that to grieving investors in Service Corp., a chain of funeral homes whose stock was considered cheap two years ago, on an Ebitda basis, when it traded at $40 a share. Since then it's fallen to about $3. Not only that, but some of Service Corp.'s loan covenants are tied to Ebitda, though Stumpp says the company is hamstrung by a cash crunch. Service Corp. says it has taken action to improve its cash flow and lower debt. Treasurer Frank Hundley also explains that Ebitda was used as a loan covenant at the urging of the company's banks.

Failing No. 3: Ebitda can make a company look cheaper than it really is. When analysts and investors look at multiples of Ebitda earnings rather than at regular earnings, they invariably wind up with a lower price/earnings multiple. That doesn't represent an actual bargain price on a stock, however.

Failing No. 4: Ebitda says nothing about the quality of earnings. As Stumpp says, the benchmark can "easily be manipulated through aggressive accounting policies relating to revenue and expense recognition" and other balance-sheet shenanigans. One example is Waste Management (see chart), which touted its Ebitda performance even as it launched an acquisition spree aimed at consolidating the trash business. Unfortunately, Waste's earnings turned out to be the real garbage after auditors found accounting irregularities going back years. "In general, we agree with Moody's conclusion that Ebitda has limited utility," says a Waste Management spokesman. "However, it continues to be used by many in the investment community for comparison."

What's more, the strategy doesn't take into account a company that amortizes costs over an extended period, when it would have been more appropriate to charge them off immediately.

Finally, Failing No. 5: Ebitda, says Stumpp, is simply not well suited for the analysis of many industries because it ignores their unique attributes. It's a one-size-fits-all number, meaning it fits no company all that well. For example, cable companies, perhaps the biggest proponents of Ebitda, have to spend huge amounts of money upgrading their technology. Same goes for media companies. (Time Warner, parent of FORTUNE's publisher, now emphasizes the "Ebita" variation in its press releases; AOL/Time Warner, however, plans to return to the standard Ebitda after the planned merger.) Because the device ignores those expenses, it makes the income statements of those companies look falsely reassuring.

What's the risk of trusting a fad accounting trick? Just look at last year's bankruptcy numbers. Of the 147 companies tracked by Moody's that defaulted on their debt, most borrowed money based on Ebitda performance. I'll bet the bankers in those deals wish they'd looked at a few other factors. Maybe it's time more investors did so too.

HERB GREENBERG is a senior columnist for