Use This Rule Of Thumb Before You Buy Another Share

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I believe the most commonly used non-GAAP term in the financial industry is the metric of EBITDA. As its name suggests, it's created by considering a company's earnings before interest payments, tax, depreciation, and amortization are subtracted for any final accounting of its income and expenses. The EBITDA of a company gives an indication of the current operational profitability of the business, i.e. how much profit it makes with its present assets and its operations on the products it produces and sells. But EBITDA also happens to be the most abused and highly manipulated financial metric out there.

Why EBITDA is misleading

Warren Buffett, Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) famous CEO, has downplayed the importance of EBITDA on numerous occasions in the past. According to Buffett, the extensive use of this metric is highly misleading for two main reasons. First, although depreciation and amortization are indeed "non-cash" charges, their nature of expense is very real. In fact, depreciation is a particularly unattractive expense because the cash outlay it represents is paid upfront, even before the asset has delivered any benefits to the acquirer. In that sense, excluding depreciation from earnings is living in wonderland. Second, EBITDA completely ignores capital expenditures on the ongoing maintenance of the business. Put differently, investors who are counting on EBITDA will never see the true results of the business because the figures relating to capital expenses will always be missing. 

The much more favorable alternative 

I believe that the best measure of a company's operating success isn't EBITDA, but the free cash flow (FCF) that the company generates. FCF measures how much cash a company generates after collecting from customers, paying employees, keeping the lights on, and buying and maintaining the machines that generate revenue. Using net income and/or earnings per share can be misleading. Those figures can be rife with non-cash expenses and "revenues" that will never lead to cash inflows. FCF filters out the noise and focuses on whether or not the business is generating cash for its owners. 

Which companies highlight FCF

Many companies use FCF in conjunction with metrics like EBITDA, but a few select companies use only the former and and never the latter. These companies are worth a close look. Take The Gap (NYSE: GPS), for example. If you carefully search for the term EBITDA in Gap's annual reports, you won't find it. It isn't there not because the company forgot to add it, but because GAP doesn't believe in imagined metrics like EBITDA. Instead, you will find extensive use of the FCF metric mentioned above. For example, in fiscal year 2012 Gap reported generating $1.3 billion of free cash flow. In its annual report, management clearly explains why it employs FCF as a gauge for success:

"We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures, as we require regular capital expenditures to build and maintain stores and purchase new equipment to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation..."

"In fiscal 2012, we generated free cash flow of $1.3 billion compared with free cash flow of $815 million for fiscal 2011. We distributed $1.3 billion to shareholders through dividends and share repurchases"

To me it seems obvious that a company that focuses on real metrics like FCF instead of imaginary ones like EBITDA will be highly shareholder-oriented. As you can see above, Gap has literally returned all of its annual cash flow back to the hands of its shareholders.

International Business Machines (NYSE: IBM) is also a strong proponent of the use in FCF. Big Blue never uses EBITDA, and focuses solely on the cash flow. According to its 2012 annual report:

"IBM has consistently generated strong cash flow, a key indicator of real business performance. In 2012 our free cash flow was $18.2 billion, a record for IBM and $12 billion higher than a decade ago. We ended 2012 with $11.1 billion of cash and marketable securities."

Not surprisingly, Buffett's Berkshire Hathaway emphasizes cash flow and refrains from any use of EBITDA. If you go through all of Berkshire's annual reports dating back to the 1970s, you won't find the term EBITDA used in the context of business valuation. Instead, you will see a strong focus on "owners earnings," which are a form of cash earnings. Specifically, Buffett repeatedly stated that trumpeting EBITDA is a particularly pernicious practice. In the year 2012 alone, Berkshire generated $20.95 billion of free cash flow. This compares to $20.4 billion and $17.9 billion in the years 2011 and 2010, respectively.

Again, it's my belief that only a company which knows how to truly evaluate its stream of cash flow, can also increase it substantially, like Berkshire has been doing over the years.  

My rule of thumb to investing

Financial reporting is the only mirror through which we can view the insides of a corporation. There's simply no other way. And that's why it's crucial to pick and choose the companies with the sharpest and cleanest glass mirrors. By choosing to invest only in companies that employ free-cash- flow metric and refrain from EBITDA, you're already ahead of 90% of investors out there. That's a great place to be. 

Solid companies selling at depressed prices have consistently helped generations of the world's most successful investors preserve capital, minimize risk, and achieve long-term, market-trampling returns. For one such company, read our free report: "The One REMARKABLE Stock to Own Now." Just click here to get started.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus