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March 2, 2014

Greenberg: Buffett Tells Investors To Get Real About EBITDA

SAN DIEGO (TheStreet) -- The best part about Berkshire Hathaway  (BRK.A) (BRK.B) CEO Warren Buffett's annual investor letters is that they always provide some kind of reality check. This year, in one sentence, he takes on one of the biggest diversion tactics of all -- one promulgated by many companies as the way they should be viewed and then gullibly accepted by investors: EBITDA or earnings before interest, taxes,… "When Wall Streeters tout EBITDA as a valuation guide, button your wallet," he wrote. Here's the windup to that comment (emphasis added by me): I won't explain all of the adjustments - some are tiny and arcane - but serious investors should understand the disparate nature of intangible assets: Some truly deplete over time while others in no way lose value. With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real costs. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenseswhen earnings are calculated -- even though from an investor's viewpoint they could not be more different. In the GAAP-compliant figures we show on page 29, amortization charges of $648 million for the companies included in this section are deducted as expenses. We would call about 20% of these "real," the rest not. This difference has become significant because of the many acquisitions we have made. It will almost certainly rise further as we acquire more companies. Eventually, of course, the non-real charges disappear when the assets to which they're related become fully amortized. But this usually takes 15 years and -- alas -- it will be my successor whose reported earnings get the benefit of their expiration. Every dime of depreciation expense we report, however, is a real cost. And that's true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet. Our public reports of earnings will, of course, continue to conform. To embrace reality, however, remember to add back most of the amortization charges we report. Buffett might as well, however, be hollering into a hollow hole. Concerns over the over-use of EBITDA to justify stock prices is decades old. I wrote a piece in Fortune about it in 1998 and again in 2000. Since then, just eyeballing it, EBITDA if anything has been more widely accepted. And if not EBITDA, "adjusted" earnings that adjust out almost anything and everything including the kitchen sink. As an example, look no further than Valeant Pharmaceuticals (VRX): To supplement the financial measures prepared in accordance with U.S. generally accepted accounting principles (GAAP), the company uses non-GAAP financial measures that exclude certain items, such as amortization of inventory step-up, amortization of alliance product assets & property, plant and equipment step up, stock-based compensation step-up, contingent consideration fair value adjustments, restructuring, acquisition-related and other costs, In-process research and development, impairments and other charges, ("IPR&D"), legal settlements outside the ordinary course of business, the impact of currency fluctuations, amortization and other non-cash charges, amortization including intangible asset impairments and write-down of deferred financing costs, debt discounts and ASC 470-20 (FSP APB 14-1) interest, loss on extinguishment of debt, (gain) loss on assets sold/held for sale/impairment, net, (gain) loss on investments, net, and adjusts tax expense to cash taxes. Whew! Of course, in the trigger-finger happy, momentum-driven investing world we currently live in, little details like that take a back seat to charts, technicals and anything and everything but the numbers that count. Reality: Until they do! Reminder: Herb Greenberg's Reality Check newsletter is up and running. -- Written by Herb Greenberg in San Diego Follow @herbgreenberg

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