The true worth of a business lies in its ability to generate cash, not just its earnings on paper.
If you’ve ever reviewed an investor pitch deck or a sales memorandum for a company, chances are you’ve come across the term “EBITDA” prominently featured. It’s often the gold standard for evaluating a business’s profitability.
For those unfamiliar, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It measures how much money a company earns before accounting for several key expenses.
It’s frequently used to show profitability and as a metric to determine a company’s sale price, typically framed as a multiple of a company’s EBITDA. For instance, a business might be sold for two or three times its EBITDA.
However, despite its widespread use, EBITDA has a major critic: Warren Buffett, often regarded as one of the world’s most successful investors. His deceased business partner, Charlie Munger, also disagreed with this metric.
Buffett’s reasoning boils down to one key idea: EBITDA doesn’t reflect a business’s real health or value because it ignores cash flow.
The Problem With EBITDA: Inside The Black Box
One of my professors, Izzy Stemp, explained the shortcomings of EBITDA with a clever analogy. He described it as a “black box” experiment. Imagine someone hands you a black box, and at the end of the year, you open it to find nothing inside. How much would you pay for that box? Maybe $20. It’s just a box.
Now imagine that the same box contains $1 million at the end of the year, with the promise of holding $1 million every year after that. How much would that box be worth now? A lot more—perhaps $3 million or even $5 million.
This analogy perfectly explains why Buffett dislikes EBITDA. A business’s value lies in how much cash it generates each year, not how its earnings look before factoring in critical expenses. Simply put, EBITDA only shows part of the story.
This distinction becomes even more critical in capital-intensive businesses, such as manufacturing or real estate. These businesses often require significant investments in equipment, inventory, or buildings.
Over time, these assets lose value, leading to depreciation costs. While depreciation might seem like an accounting line item, it represents actual expenses that can’t be ignored.
The Hidden Costs Of Capital Investment
For capital-intensive businesses, depreciation reflects the ongoing need to reinvest in assets to keep the company running. Your business is effectively decaying if you’re not making these investments to replace or upgrade your equipment, inventory, or facilities.
To remain competitive and productive, you must continually invest—usually at a rate similar to your depreciation expense. Here’s the problem with EBITDA: it ignores these capital investments.
A business may appear profitable on paper because EBITDA excludes depreciation and other costs. However, as Buffett often points out, a company can be EBITDA-positive but cash flow-negative. And when a business runs out of cash, no amount of EBITDA will save it.
A Real-Life Example Of EBITDA’s Flaws
I once worked with a client who ran a highly capital-intensive business. He had been trained to focus on EBITDA as the primary measure of success. He reported positive EBITDA each year and believed his company was growing in value. However, he overlooked the cash required to fund his capital investments and pay interest on the company’s debt.
On paper, his business seemed profitable. It was a $100 million company generating $10 million in EBITDA. However, the firm also needed $15 million annually to cover investments and interest expenses. That meant the company lost $5 million in cash yearly, even though EBITDA suggested otherwise.
Eventually, the company ran out of cash and had to close. The owner had focused so much on EBITDA that he ignored the business’s real financial health: its free cash flow.
Why Warren Buffett Values Free Cash Flow
Free cash flow, unlike EBITDA, represents the actual cash a business generates after accounting for all expenses, including capital investments and interest payments. It’s the cash left over to reinvest in the business, pay dividends, or reduce debt.
When Buffett evaluates companies, he zeroes in on free cash flow as the accurate measure of a business’s worth. He wants to know how much cash will be in the “black box” at the end of the year. This approach helps him avoid businesses that look profitable on paper but fail to generate enough cash to sustain themselves.
Selling Vs. Buying A Business
Despite its flaws, EBITDA continues to dominate investment prospectuses and sales pitches. Focusing on EBITDA can help you attract buyers and secure a higher sale price if you’re selling your business. Investment bankers often use EBITDA to frame the valuation of similar companies and highlight the profitability of your business.
However, if you’re on the other side of the table—buying a business—you should take a lesson from Warren Buffett. Don’t rely solely on EBITDA to gauge a company’s health. Dig deeper into the company’s financials to evaluate its free cash flow. This will give you a clearer picture of whether the business generates enough cash to support its operations and future growth.
The Bottom Line: Focus On Cash Flow
While EBITDA may be a convenient way to compare businesses, it’s an incomplete measure of financial health. For capital-intensive companies, ignoring the impact of depreciation, interest, and capital expenses can lead to a misleading picture of profitability.
Whether you’re running your business, preparing it for sale, or considering buying a company, always look beyond EBITDA. Focus on free cash flow to understand the real value and sustainability of the business. Warren Buffett’s advice is simple yet powerful: a business’s worth lies in its ability to generate cash—not just its ability to look good on paper.
