EBITDA: Cooking the Books

A Diversionary Tactic: A Half-Century Long Psyop of Specious Subterfuge and Ostensible Subversion

HABITS ARE HARD TO BREAK 

You use EBITDA because of what happened half a century ago. The mass adoption of EBITDA is often attributed to the multi-billion-dollar cable industry.  

The gist of the story is that a guy named John Malone, who was a media mogul who became the CEO of a cable and media corporation in 1973 used EBITDA to communicate the company's ability to service its debt obligations to lenders and bondholders and to assuage the debt holder's insecurities around the high levels of leverage on the balance sheet.  

You see, prior to the late 1980s, the statement of cash flows, let alone cash flow from operations was not a required reporting metric for public companies in the United States. Due to the large depreciation expenses of the industry, net income wasn’t a suitable metric for gauging the ability of the cable companies to pay the interest on their debt, although they had the cash flows to do so. Thus, the use of EBITDA fell into heavy practice. It was an attempt to help bond holders better understand the company's ability to pay them back.  

The statement of cash flows, including the cash flow from operations figure, was not mandated by accounting standards until 1987. 1987 is when the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 95 (FAS 95), which required public companies to provide a statement of cash flows. 

This means that there was a solid decade of EBITDA reporting without any official statement of cash flow. It was out of necessity that the invention of EBITDA arose. And this decade plus head start also allowed EBITDA to entrench itself into financial reporting.  

All of this means that the reasons that EBITDA came to exist are in large part no longer the reasons that it currently exists. Like I said, the statement of cash flows reconciled the issues which created the need for EBITDA. And yet, here we are still using EBITDA. But why?  

FOLLOW THE MONEY 

People love familiarity and simplicity and disdain complexity and comprehension. And management teams love a reporting metric that affords them flexibility to finagle a flattering figure.  

EBITDA is now a means to a different end.  

It now serves as a more flattering, favorable and fungible figure. It’s been misused and co-opted from those who initially had good intentions by more nefarious actors trying to obfuscate. This is all due to the beneficial and privileged picture EBITDA provides.  

Just imagine if analysts had to switch from EBITDA TO CFO. The multiple rerating would be significant with CFO acting as the new fill in for EBITDA. There are a lot of companies with positive EBITDA but negative cash flows.  

Analysts and investment banks would have to change their estimates and worse, downgrade customers & client's companies when switching from EBITDA to CFO.  

There’s this open secret kayfabe that occurs. People say they use EBITDA as a proxy for cash flow but most of them know that doesn’t hold up to scrutiny. But that’s why they use it, to maintain an air of plausible deniability one step removed. It allows things to trade higher than they actually would if we were referencing the metric (CF) that the other metric (EBITDA) is supposedly representing and is a proxy for.  

It’s a big game of pretense and pretending. Yes, billions and billions of dollars sloshing around on pretend figures which don’t translate well to the alleged thing they’re supposed to represent - cash flow.  

Underwriting and issuing shares come with lucrative commissions. Do you think that the other investment bankers jockeying for position to the trough of free tendies are going to rock the boat by using a different and less flattering figure? Especially when the other investment banks are more than happy to play along. These institutions have close working relationships with the management teams. Why would they bite the hand that feeds them? 

Honesty, integrity, honor…lol, that’s a naive and delusional way to think. Simply put, it’s an I’ll scratch your back if you scratch my back dynamic and feedback loop that keeps the house of cards known as EBITDA propped up.   

And even if there aren’t diabolical and Machiavellian dynamics at play, do you think the C-Suites of these firms are going to let their analysts write freely and truthfully? That wouldn’t be good for business or their bonus. 

And by the way, the people paying for the analysis want to be lied to too. It’s a convoluted and distorted mess. They’ll stop buying your services if you won’t tell them what they want to hear. In all bubble situation analysts keep pushing out dribble and ludacris forecasts because their customers don’t want to be told to sell out of their stocks as they’re going up each and every day. Russell Napier pointed out this fact during the lead up to the Asian financial crisis.  

And don’t forget, the investment bank clients have customers and clients themselves, and they certainly don’t want to prudently sell out of stocks while watching their peers get richer.  

Like I said, people want to be lied to and they’ll punish you for telling them the truth.  

Then consider that analysts are pressured, either explicitly or implicitly, to highlight the metric that company executives prefer, even if it doesn't provide the most complete or objective representation of that business. Maintaining access and good standing with these corporate clients is important for securing future investment banking deals and commissions. 

The vested interest that analysts' employers have is in securing lucrative business from the companies they cover. So, do you think they’ll be using more or less rigorous metrics? And it’s this dynamic which compromises the so-called independence and objectivity of the analyst community.  

WHY DO YOU USE EBITDA?  

At this point, we’ve discussed the origins of EBITDA and why institutions and financial firms continue to use it. But that doesn’t necessarily answer the question of why does retail use EBITDA?  

Is it because they’re financially illiterate and vulnerable to misleading metrics? And is that the consequence of them being overly impressionable due to being naive and ignorant, which has caused them to develop ill-conceived notions and misguided beliefs?  

For instance, no one is asking the following line of questions.  

Isn’t EBIT known as operating profit? If so, then why is EBITDA often referenced as operating profit? Wouldn’t this make EBITDA adjusted operating profit since it further adds back D&A? And doesn’t that then make Adjusted EBITDA (a commonly referenced figure) Adjusted, Adjusted operating profit i.e. AAEBIT?  

How many turns of adjustment are there? Shouldn’t adjustments for SBC be an adjustment in and of itself, as well as impairments, restructuring costs and so on? Shouldn’t that make it Adjusted, Adjusted, Adjusted EBITDA. And as we’ve already discussed, EBITDA is Adjusted, Adjusted operating profit derived from EBIT. So now we’re up to 5 adjustments.  

AAAAAEBITDA 

That is what it would look like if we didn’t lump together all the adjustments into a categorical placeholder phrase innocently referred to as “Adjusted”.   

And if we were using Tilray as an example, we’d still have several more adjustments to make.  

“Adjusted EBITDA is calculated as net income (loss) before income tax benefits, net; interest expense, net; non-operating income (expense), net; amortization; stock-based compensation; change in fair value of contingent consideration; purchase price accounting step-up; impairments; inventory valuation allowance; Other than temporary change in fair value of convertible notes receivable; facility start-up and closure costs; litigation costs; restructuring costs, transaction (income) costs and (Gain) loss on sale of capital assets – non-operating facility.” 

Or, how about everyone's beloved Curaleaf. They reported earnings today. Look at this foolishness. Acting as though it’s even remotely appropriate to pretend like a metric that excludes “add-backs” such as rent, PR and other facility costs is a worthwhile metric to report. But desperate times call for desperate measures.  

Financial engineering, mental gymnastics, cognitive dissonance and a willful blind eye towards corruption can take you to some interesting places. Places which appear contradictory and inconsistent but that’s due to the compartmentalization and isolated one-off treatment of reality.  

Each adjustment is a so-called “one off” and then it gets lumped together under a singular recognition and casually referred to as “Adjusted”.  

The way I see it, practically everyone is complicit, complacent and compliant…even I.  

When you confront someone as to their EBITDA usage, you’ll find that most responses are characterized by obfuscation and deflection. They resort to appealing towards ostensible technical details to avoid directly addressing the core issue (why the preference for EBITDA over cash flow). And it’s not just in finance. As I’ve said before, cope, fallacy and bias know no bounds and you take it everywhere you go.   

You find that most people are just one large rhetorical smokescreen. 

What might some of these technical details look like to explain their usage of EBITDA?  

People will give ostensible reasons, such as:  

1. EBITDA helps gauge a company's operational efficiencies 

2. It helps facilitate comparisons between companies within an industry  

3. It helps determine if it’s trading at a decent multiple 

You’ll note that these reasons apply just as well to many other metrics. Those above 3 reasons are tangentially associated but not mutually exclusive to EBITDA.  

Indeed, those are reasons to use EBITDA but those aren’t the reasons that they use EBITDA. The reasons they use EBITDA is due to a well-meaning attempt made half a century ago that’s now become a full blown psyop to the tune of a specious subterfuge and ostensible subversion.  

I assure you; these people didn’t sit down and consider the set of valuation metrics to aid them in their investing to then consciously decide that EBITDA was the way to go about it. Let's not kid ourselves, they use EBITDA because they’re a product of their environment, for better or for worse.  

People will bullshit you to the ends of the earth if it means that they can keep intact their sense of autonomy, intelligence and intentions (A.I.I.). People are largely unconscious post hoc rationalizers. And when they’re not busy being that they’re busy trying to deceive you to save face in a brand management fashion with their A.I.I. as a primary concern.  

In all probability, people that use EBITDA do so because that’s what other people do so therefore, they do it too.  

Conformity & consensus. 

So, will you or the people I’m speaking about be more than happy to exchange their P/EBITDA metric for P/CF or P/FCF? Or how about EV/CF or EV/FCF?  

Highly unlikely.   

This is how you discover that there’s other motivational reasons and contributing factors for their behavior. After all, if the reasons they cited are indeed the reasons for them to use EBITDA, then they’re not losing out on anything by switching metrics, right?  

It’s only once you keep constant your comparisons, control for the variables and compare to counterfactuals that the game reveals itself.  

You come to realize that their answer is intellectually dishonest and disingenuous. Their preference is towards rhetorical smokescreens not in addressing the relative merits of the metrics they’re using. And if they do discuss those merits, they only do so in isolation and not relative to the set of potential metrics they could be using alternatively.  

They’re more concerned with pre-selection, third party confirmation, appeal to authority, and peer validation. And all of those mental shortcuts have led them to use EBITDA.  

On a certain level of analysis, you could say that EBITDA is like communism, in theory it sounds nice but in practice it doesn’t turn out that well. Why? Because it almost always devolves and deteriorates into something else. Because once you intwine it with the human condition and put it into practice it doesn’t quite look the same anymore. People's propensity to make tweaks and adjustments is insatiable. In this case, it often transforms into ADJUSTED EBITDA. Some versions of Adjusted EBITDA merely remove SBC while others, such as the Tilray example mentioned earlier, adjust for much more. The category of “Adjusted” becomes the void to shoehorn everything unflattering into.   

The phrase, “Give an inch, take a mile” comes to mind.  

Another term for Adjusted EBITDA could be EBITDABSBCAIRCACLC.  

Which stands for: EBITDA Before Stock Based Compensation, Asset Impairments, Restructuring Costs, Acquisition Costs, Litigation Costs.  

But you can’t overly say that. Because otherwise people will say, “hold the breaks”. You can’t bring it to conscious attention. Out of sight, out of mind. It’s much easier to lump all of that together and place it into the set called “Adjusted” or “A” for short. That’s pretty insidious if you ask me.  

Of course, there’s a specious argument provided for why each one of these things are inconsequential or should be extracted out. Take for instance SBC. They’ll tell you that it doesn’t reflect the operational performance of the business and thus it’s a distraction from that, thus the exclusion. But that misses the point to some extent. A company being valued on EBITDA that grows 100% has much different results in regards to the share price if they also doubled the share count in that same timeframe.  

My point is, ultimately shareholders care about shareholder returns and operational metrics are supposed to theoretically reflect the kind of returns a shareholder should get. But SBC can create a disconnect. Operational improvements should correlate to share price appreciating in value but it gets offset and canceled out by SBC dilution.   

It’s not like they don’t know this. Their job is to gaslight you to think that that’s ok.  

It’s similar in kind to nominal vs. real wages. Growing your income by 100% isn’t as impressive sounding once you realize that your purchasing power in that same time period has deteriorated by half. Now just imagine someone trying to gaslight you by congratulating you on your wages appreciating 100% while ignoring your purchasing power falling by half. Well, what management is doing is similar in kind.   

Just remember, at the end of the day you should care about your shares appreciating in value and your purchasing power remaining stable or improving.  

The problem with this is that most people think in nominal terms. In this sense they act with a numerator bias. People focus on the growth of EBITDA or their wages, without accounting for the corresponding increase of shares or decline of purchasing power. But this is what people do, they disproportionately weigh things in a distorted fashion.  

This is why governments prefer printing money over raising taxes. It’s functionally the same but is much more tolerable to the average person. People think in absolute nominal terms more so than real relative terms. The numerator in these examples is more psychologically salient and compelling than the more abstract and less tangible concept of purchasing power and factoring in multiple variables such as EBITDA & share count.  

There is no ready solution to this on a broader scale (other than people getting desperate enough), but you can tend to it on a personal level.  

Adjusted EBITDA, let alone EBITDA, excludes such things as Capex and debt servicing. And it’s being used in an industry which has historically spent vast amounts on Capex and debt servicing… the cannabis industry.  

That’s really worth thinking about. It sure is an interesting juxtaposition. The retail crowd might not know how irresponsible and disingenuous it is for cannabis management teams to use a figure which excludes Capex & debt servicing i.e. EBITDA, but you know who does know? The management teams.  

If all else fails, the EBITDA user has on ready standby the exemption phrase of, “Of course it’s not an end all be all and it should be used as part of a comprehensive model for gauging a business.”  

This is the caveat clause and thought terminating cliche that’s so often used by these sorts of people. It’s similar to how people use “We’re all born of sin” or, “No one is perfect” as an excuse for inaction and deflecting accountability. It’s the same line of BS that people use when taking psychiatric drugs or medication for their health. It’s supposed to be part of a comprehensive plan but if we’re being honest, it’s rarely used that way.  

THE RISK YOU RUN WITH SUCH A SIMPLE QUESTION 

What do these 2 questions have in common? 

4. Why do you do chin ups with a partial range of motion, hyperextend your neck instead of retracting your scapula and quickly descend through the eccentric portion of the rep?  

5. Why do you use EBITDA?  

They’re trying (unconsciously) to shortchange success. 

You’ll irritate them with such questions and give them negative feelings towards you.  

They don’t know why they do what they do but they’ll happily give you a bullshit answer.  

They’re both a litmus test for gauging self-awareness and honesty.  

The kayfabe that people play on a day-to-day basis should never have its 4th wall broken by bringing attention to it. Meaning, that the unspoken fictions & illusions that we socially act on shouldn’t have attention brought to it. No need to rock the boat. You play your role, adhere to certain social conventions and never draw overt attention to the artifice behind it. To break the 4th wall is to ask for trouble. It disrupts the smooth function of social interactions and relationships. It makes people self-conscious and they hate feeling self-conscious. To highlight their performative art gives them bad feelings and makes them quite uncomfortable. They refuse to deviate from their script. Essentially, you can’t go around essentially trying to red pill people who chug bottles of the blue pill every day.  

Maintaining a level of discretion and respecting the unwritten rules of social exchange is crucial for preserving social cohesion and interpersonal comfort.  

Anytime, you ask anyone why they’re doing what they’re doing, you run a high risk of knocking the slats out from underneath them, as it’s often a weak and superficial veneer, and exposing them to the abyss of their ignorance. An ignorance they work extremely hard to maintain. This is why discretion and discernment are crucial for such “innocent” conversations. You’re opening up Pandora's box. 

I’ve found that in order to preserve a relationship you can generally only go two layers deep. And generally, the second question is pushing it.  

Why do you use EBITDA? 

But the reasons you cited for EBITDA equally apply to CFO, so why not CFO?  

That’s it. In all probability they’ll either say IDK or awkwardly stumble through a partially coherent attempt at post hoc rationalizing. Pressing it any further bypasses the point of diminishing returns and throws you into negative returns. They might feign politeness for the remainder of the conversation but I assure you once they walk away, they’ll be saying nasty things about you.  

Why?  

They have never thought that far and now you’re implicitly attacking a metric that they’ve incorporated into their ego. Everything is attached to a story. They use EBITDA because they’re smart and decisive and EBITDA is their chosen metric as a consequence of their smart decisiveness. To say that they got EBITDA wrong is to say that they’re wrong. And only bad people are wrong. How dare you call them bad! And who do you think you are, Mr. Self Righteous?  

IN CONCLUSION 

Status quo thinking, lazy legacy thinking, herd mentality, institutional phase-lock, personal incredulity and intellectual lethargy are all contributing factors as to why many people use EBITDA.  

But people are so hell bent on trying to provide virtuous reasons as to why they do what they do to save face that they never assess their actual behavior or motives. They just keep on keeping’ on. And this only emboldens and entrenches us in our poor performance due to our poor thinking and limits what we could alternatively achieve. Adopting self-sabotaging mental models might comfort your afflicted ego and assuage your insecurities but I assure you it’s at a cost. And since we all claim to think in risk/reward terms, we probably should reflect whether it’s really worth acting that way. 

You find out that the story of EBITDA is similar to the “5 monkey experiment” aka the “monkey ladder experiment” And how one monkey passes on behaviors to the next monkey even though the adopting monkey doesn’t know why. Similar to those in the study who pulled one another off of a ladder for reasons that they didn’t know until they all were pulling monkeys off that ladder and yet none of them ever experienced the reason why they were doing it in the first place, we are largely clueless as to why we use EBITDA.   

If you haven’t heard of this experiment it was conducted by Harry Harlow.  

Oh, this just in… none of that happened and it was falsely attributed to Harry Harlow due to his work with monkeys. And just like that, I too, have fallen for saying and doing something because others did and said something and it all turned out to be false.  

This is why we must question the concepts in a statement or story as much as the statement or story itself.  

P.S. The ending here was beautiful. I was actually looking up the monkey ladder story to brush up on some details to draw a comparative metaphor. And in that process, I discovered that it's seemingly an apocryphal story. Lol.  

Talk about a beautiful self-own and irony. But nonetheless, it only further emphasizes the points I’ve made here today.