Investment Mantra: Why Warren Buffett and Charlie Munger calls EBITDA a tool to mislead investors

As Q1 earnings dominate investor focus, Warren Buffett and Charlie Munger's criticism of EBITDA is back in the spotlight. Buffett called it a tool to mislead investors, while Munger famously dubbed it 'bullshit earnings', arguing that ignoring depreciation and other real costs distorts a company's true financial health.

Munger's Blunt Take on EBITDA

Late investor Charlie Munger once famously said that EBITDA was 'bullsh*t' earnings. "I think that, every time you see the word EBITDA, you should substitute the word ‘bullsh*t’ earnings," he said.

Buffett says EBITDA a way of conning investors

Sitting beside Munger, Warren Buffett said that not thinking of depreciation and expenses is 'absolutely crazy'. "I think of a very few businesses where depreciation is not a real expense," he said, explaining it with the example of Berkshire’s investment in gas pipeline companies. "At some point, they will need repairs. Depreciation is real and it is the worst kind of expense," he added.

"People who use EBITDA are either trying to con you or they are conning themselves," Buffett said.

Buffett on adjusted earnings practices

In one of his annual Berkshire Hathaway reports, Buffett criticised financial reporting practices that deliberately inflate earnings figures. "Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, adjusted earnings that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of restructuring costs and stock-based compensation as expenses,” he said.

He added that he and Munger want managements in their commentaries to describe unusual items - good or bad - that affect the GAAP numbers. "But a management that regularly attempts to wave away very real costs by highlighting adjusted per-share earnings makes us nervous.

That’s because bad behavior is contagious, CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be helpful as well," he said in his 2017 annual letter.

What Makes Buffett and Munger Cringe?

The legendary investor said he and his partner Charlie Munger cringe when they hear analysts talk admiringly about managements who always make the numbers.

"In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers," he wrote.

(Disclaimer: The above article is meant for informational purposes only and should not be considered as any investment advice. ET NOW DIGITAL suggests its readers/audience to consult their financial advisors before making any money-related decisions.)