EBITDA Is Not Cash Flow

Earnings before interest, taxes, depreciation and amortization (EBITDA) is often used synonymously with cash flow. Relatedly, a reader recently took exception to an article about NovaMed, arguing that the company derives significantly more cash than the article implied, due to cash flow from depreciation. For most companies, however, using EBITDA as a proxy for cash flow will lead to serious errors in valuation.

In asset intensive businesses, depreciation is a large part of expenses. In many cases, managements will discuss EBITDA numbers to make results look better than they are. Yes, cash "provided" by depreciation can be used to pay down debts, and so comparing EBITDA to debt servicing requirements can be useful; however, using EBITDA in any shape or form related to a company's valuation should be used extremely cautiously. This is because in most cases depreciation is a very real charge, as assets must be replaced (at a real cost) for the business to continue earning. Unless the investor can determine that an asset is being depreciated faster than its useful life, it is very dangerous to assume any cash flows arising out of depreciation expenses.

Furthermore, due to inflation, the prices of most assets rise over time. As such, depreciation actually understates the required replacement costs of assets in the majority of cases. Therefore, instead of being counted out, depreciation should be counted up.

Don't believe me? Consider Warren Buffett's take on EBITDA. Finally, consider how harmful value investor Seth Klarman considers EBITDA to be.

When estimating a company's future cash flows, allowances must be made for the replacement of depreciating assets. Otherwise, one is assuming that expensive, fixed assets the company owns are totally free, which will lead to great errors due to ridiculous valuations.

Disclosure: None