Fool Me Once Or Fool Me All The Time

On June 2, 2018 Jason Zweig’s article in the Wall Street Journal was titled, “The Fanciful Alphabet Soup Companies Use to Fool You.” The premise of the article was most of the financial jargon used to provide insights into companies’ health are make-believe and don’t reflect actual conditions, i.e. true profitability.

First, five points from the article I found interesting and then some comparisons to other areas of business.

  1. This goes back to before the stock market crash of 1929. A 1932 research paper showed firms had loaded up with cash and post-crash, “companies were flush with cash and investors beleaguered,” which they wouldn’t pay out.
  2. Investors have always looked at net income as a way to assess businesses. But companies have come up with new measures of “modified” profit with the chief culprit being the term Ebitda (earnings before interest, taxes, depreciation, and amortization). Zweig writes that any form of modified profit isn’t cash flow.
  3. Fifteen years ago, Charlie Munger, Warren Buffett’s business partner, called Ebitda, “bulls*#t earnings. For more, just Google the terms Warren Buffet and Ebitda. My favorite is when Buffett compares people who buy into the term Ebitda to those who think capital expenditures are funded by the tooth fairy.
  4. There’s now a plethora of Ebitda clone terms including those showing “profit” before things like stock-based pay, marketing, business development, and administrative expenses. Zweig asks, “Can “Ebidtdaft” be far behind?”
  5. So far this year there have been over 450 documents filed with the SEC with suffices tacked on to Ebitda. One analyst wonders if pretty soon companies will start multiplying earnings as a measure of performance (yes, it’s sarcasm).

So let’s look at the above in the context of other areas, starting with advertising. A perfect example is car dealers who advertise free oil changes for life. Well, if it sounds too good to be true…. A car guy told me about the hitch in the program. You’ll get the oil change plus a list of work you need to do on the car. If you don’t have them do that work the extended warranty and oil changes go away. Like the above, it’s knowing the details (in the fine print).

Now for what I see every day in the buy-sell world. First, most of the creative Ebitda terms in the public market have nothing on the creativity used when selling businesses. Adjusted Ebitda or adjusted earnings are the norm. I get the feeling many people, even in my industry, don’t understand the difference between profit, Ebitda, and cash flow.

There’s a tendency to “add-back” almost any expense deemed “unnecessary” to running the business. To some people, this list includes:

  • Owner salary (really interesting when adding back the salaries of multiple, departing owners).
  • Medical insurance expense.
  • Marketing expenses (the marketing didn’t work so it’s really profit).
  • Owner “perks” like cell phone, car, travel to conferences, etc. (as if all owners don’t deduct these).
  • And a recent one I’ve seen, the expense for research and development (for a company with a patented propriety product).

Conclusion

The magic of inflated earnings is all around us, and not just in the financial world. Misleading ads, inflated resumes, stories about high school athletic accomplishments (Glory Days as Bruce Springsteen called them), and many other things. The good news is most people see through these things. The problem is some don’t see through the fog and make decisions based on false information.

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