Adjusting for the Adjustments

February 20, 2020

Adjusting for the Adjustments Photo

Source: S&P Global Market Intelligence LLC and Standard & Poor's Financial Services LLC

Charlie Munger, one of the greatest investors of all time and the vice chairman of Berkshire Hathaway, was on CNBC recently warning investors about the quality of earnings. He was referring to investment bankers’ use of earnings before interest, taxes, depreciation and amortization (EBITDA) and adjusted EBITDA as an inaccurate reflection of how much money a company makes. The proliferation of EBITDA and adjusted EBITDA in the investment community has become almost universal. Management teams refer to it when discussing mergers and acquisitions (M&A) in terms of the enterprise value multiple paid for a business. They also use it to provide earnings guidance as a representation of the company’s unlevered earnings power and cash flow. It’s thought of as a great way to compare businesses with different capital structures on a more like-for-like basis and to reflect total leverage.

I use EBITDA daily when determining in which companies to invest. With that said, I also look at a company’s true free cash (which I define as cash flow from operations less capital expenditures) and reconcile that with the EBITDA I’ve calculated based on my own adjustments and reconciliations. This helps to get a more accurate depiction of a company’s earnings power and its cash flow potential after it reinvests in its business. I use my adjusted EBITDA to measure leverage (Total debt/EBITDA) and use that as one way to determine credit risk.

I have to make my own adjustments to companies’ reported EBITDA because not all companies have the same definition. Moreover, some companies provide an adjusted EBITDA number which adds back one-time costs incurred for transactions, potential cost savings initiatives, merger synergies, management fees and restructuring charges, among others. Over time, the definitions of adjusted EBITDA have become increasingly lenient and their depiction of a company’s true cash flow potential may be less realistic. This can lead to a variety of issues. If bankers, management teams and investors are using an inaccurate portrayal of a company’s earnings ability, then future results could disappoint and lead to major changes in the cost of capital for a business.

In September of 2019, S&P Global Ratings published a report depicting EBITDA and EBITDA add-backs, outlining how actual results differed materially. They looked at a sample of 31 companies that were involved in M&A or leveraged buyout transactions in 2016, and followed the companies’ results in 2017 and 2018 to see how accurate their projected EBITDA (including add-backs) was compared to their actual results. As depicted in this week’s chart, none of the companies exceeded expectations in 2017 and only 6% did so in 2018. Moreover, 90% of companies in the sample missed their EBITDA projection by 10% or more in 2017, and almost one-third missed their projected EBITDA by a staggering 50% in 2017 and 2018! It’s pretty evident why Charlie Munger was so concerned about the quality of earnings.

Key Takeaway

 EBITDA can seemingly be “adjusted” or massaged to the point where it’s not truly reflective of a company’s actual earnings power. This can result in leverage multiples being understated and acquisitions of seemingly better value than is actually the case. However, it is up to investors and management teams to make their own estimates and adjustments to reconcile back to a true free cash flow and true earnings potential. It’s not an easy task, as investors must rely on the numbers provided to them from the bankers and companies as the starting point.  Management teams and investors then make their own assumptions about the future, which clearly no one knows with any certainty. When I determine who to lend money to, I am underwriting the credit risk to my own adjusted EBITDA. To make things even more confusing, investors are required to “adjust” the adjusted EBITDA. This, in and of itself, makes it apparent that Charlie Munger and others have been skeptical for good reason.


Honeyman, Olen and Hanna Zhang. (2019, September 19). When the Cycle Turns: The Continued Attack of the EBITDA Add-Back. Retrieved from S&P Global.

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Tags: Adjusted EBITDA | EBITDA | Earnings

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