I have mentioned before the differences between earnings and cash flows, and how cash flows can be used to make sure that the earnings reported by a company are real. Here I address differences between accrual accounting (used in earnings reports) and cash accounting. I also give my opinion of EBIT and EBITDA. Earnings are the basis for P/E ratios and are the number to which most people pay attention. However, earnings are not real cash going into or out of the company.
This is because earnings includes non-cash items. At first this may seem stupid—why confuse people with charges and gains that do not actually occur? This would be stupid, but the non-cash items in earnings are used to approximate real losses and gains that truly occur yearly but are paid infrequently. The two main negative accruals are depreciation and amortization. These two terms can be used (for the most part) interchangeably. They both refer to the decrease in value of equipment, buildings, or intangible assets. For example, my 2003 Mazda Protege was worth $15,000 when new. To account for the reduction in its value (its depreciation) each year, I could look at the Kelley Blue Book Online and see what its value is.
The depreciation would then be the amount of value the car has lost that year. If I ever planned to sell the car, this would be a logical way to track its value. However, since I plan to use the car until it dies, I am amortizing it over a period of about 8 years (at which point it should have over 100,000 miles on it). Therefore, I take a charge of $1,875 each year. After I have amortized the car’s full value and it is listed in Quicken as worthless, I will buy a replacement car. If the car still runs fine at that point, I will not replace it, but that is a good point at which to estimate that the car will be worthless. The car could continue running for 13 years or it could die tomorrow. The 8 years and 100,000 miles are just guesses.
This highlights the main problem with accrual accounting: depreciation and amortization are just estimates. Let’s continue with my car example. Say I actually use my car in a taxi business (and I have 99 other cars in my taxi fleet as well). If each car nets me $20,000 per year (including all my fees, taxes, and expenses except depreciation), then I can say that the quasi-rent from the car is $20,000. Because I want to count my cars as assets only while they can be used in my taxi business, I will want to amortize them over their useful lives. If I expect each car to cost $20,000 and be useful for 5 years, then I would take a charge of $4,000 in depreciation per car per year. That way my earnings will reflect my real costs of doing business and not swing wildly from apparent profitability in years in which no cars are purchased to apparent losses in years in which many cars are replaced. In this case, when I buy new cars, the money is not subtracted from earnings, because the depreciation has already reflected the cost.
If I had just one car, there would be a fairly large chance that my estimate would be way off. With 100 cars, however, my estimates of depreciation will be fairly accurate on average (because on average my taxis will only be useful for 5 years, while some may last only 3 years and others may last 8 years). In the example above with my Taxi business, my yearly earnings would be $1.6 million ($2 million – $400,000 in depreciation). This is a good estimate for how much I real take-home profit I would have, because my depreciation should on average be equal to my spending on replacement cars. Like with amortizing cars over 5 years, assets are amortized over different periods of time. Many types of industrial equipment are amortized over 10 years, while buildings are often amortized over 30 years. For the most part, this works. In an industry in which there are no technological advances, depreciation and amortization should completely cover the amount of money that will have to be spent to keep the company producing at its current level. Assuming prices do not change, reported earnings will be a good measure of free cash flow (FCF).
Earnings will not equal FCF because of other accruals such as receivables, accounts payable, goodwill, and future tax benefits / liabilities. As long as these do not change greatly (and they should not) then earnings will be directly proportional to FCF and close to FCF. However, what if there is technological change? In this case, the equipment will have to be replaced before it is worn out. Therefore, depreciation will not cover necessary reinvestment and much money will have to be reinvested just to keep the same level of production and the same level of profitability. In such industries we must be careful to make sure to calculate the owner earnings. One way of doing this is to take total earnings, add back depreciation and amortization and then subtract average yearly spending on equipment that is not directly related to expansion. With our taxi company we could thus take total net earnings, add back the depreciation on our cars (arriving at $2 million), and then subtract the average amount spent on buying replacement cars (let’s say $300,000 per year). We do not count new cars added to the fleet for this calculation because they represent expansion and an increase in earnings power, not simply maintenance of current earnings power.
For my taxi business example, true earnings ($1.7 million) are actually greater than GAAP earnings ($1.6 million) by $100,000. In this case, earnings underestimates true profits. Oftentimes, the reverse is true; good examples of this include the steel and auto industries over the last 100 years. Now it is time for alphabet soup! Many analysts use terms like EBIT and EBITDA, and many use EBITDA as an approximation for FCF. EBIT is earnings before interest and taxes. EBITDA is earnings before interest, taxes, depreciation, and amortization. While I cannot be accused of overestimating analysts’ intelligence, the use of EBITDA in any detailed calculations strikes me as particularly stupid. EBITDA excludes depreciation and amortization as well as interest and taxes. Nothing is added back to account for replacement of capital goods. Thus, EBITDA is only a very crude measure of cash flow.
Of course, there is nothing wrong with crude approximations if we treat them as such. EBITDA is a decent number to use as a quick and dirty estimate of free cash flow. Do not use it for any serious estimations. EBIT, however, is more useful. It measures earnings before tax and interest expense. This is useful if we want to look at the pure operating earnings efficiency of a company. There are many accounting tricks to lower tax rates. Those do not affect the underlying profitability of a certain business. Likewise, companies can increase earnings and lower their P/E simply by increasing their debt load and using the money to buy back shares. Thus, P/E ratios can be deceiving. Using EBIT and something called Enterprise Value, we can come up with a better measure of value than a simple P/E ratio. Enterprise Value (EV) is the market cap of a company added to the debt the company holds (minus its cash). EBIT / Enterprise Value is thus a better measure of the underlying value of a company than P/E.
It is a measure of the true cost of the business in relation to the income of the business. Let us consider two businesses. Company X has no debt, while company Y has $50 in debt. Suppose Company X is selling for $60, while company Y is selling for $10. (See below for their financial information.) Which is the better buy? By looking at P/E ratios, it may appear That Y is cheaper (with a P/E of 3.33), compared to X (with a P/E of 10). However, they have the same ratio of EBIT / EV (10/60 for X, 10/ (50 +10) for Y). Just as a $90K house is worth $90K whether it is bought with cash or with a $75K mortgage, these companies are worth the same amount. They are just financed differently. By screening for companies using EV/EBIT, we can find companies that do not rely upon large amounts of leverage (debt) to produce a large revenue stream. Because companies with lower debt are safer, this should also help us find lower-risk companies.
Disclosure: this article was written two years ago and originally published elsewhere.