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Understanding Warren Buffett's Most Important Quote


You know,  Warren Buffett is The Man.  He is the EF Hutton of modern times.  When he speaks, people definitely listen.  He seems to have so many witty quotes floating out there on the internet, you almost wonder if he really has said them all. 

Here are some sharp and short ones that come to mind:

  • "Rule #1: never lose money; Rule #2: Don't forget Rule #1"
  • "Wall Street is the only place that people ride to in a Rolls-Royce to get advice from those who take the subway."
  • "Price is what you pay. Value is what you get."

Many of us have heard these before.. and we all probably had a little smile after reading them. After all, the advice readily makes sense - these quotes are simple, straightforward and wise.

Well, while I like these Buffett quotes as well as host of others, the one that I've found with the most wisdom is none of the above.

In my opinion, here is his most important quote:

"We’ll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them."

Well, the quote above is not short, and not necessarily simple.. but from the tone, you get the feel that Mr. Buffet is rarely this direct and bold about issuing a warning about the types of managers and/or companies to avoid.

EBITDA (pronounced as "EEE-bit-da") is a modification of the profit formula,  you know, Profit equals Revenues minus Expenses.  Again, what's important to remember is that it is a modification of the profit formula in an attempt to "simplify" things.  Unfortunately, it's a very deceptive modification, that old-school businesses and not-so-wise managers widely used a while ago until many realized that this overly simple modification had serious analytical deficiencies.

Well, with just a little of your patience, I'm going to explain the meaning behind Mr. Buffett's last quote and at the same time raise you investing game substantially.  I have been in many a meeting, when the senior person is ranting on about EBITDA ... much to my own disbelief.  In a minute, you'll see why this is such a major reason for concern.

This short diversion will be well worth your time, ... its about accounting.  Now don't run away - the two key concepts here are quite simple.

The two key points regarding business accounting are:

1.  The purpose of accounting is to measure a company's performance over several years, not each and every year individually. Accounting does this by realizing that, at times, a company spends money on equipment that will last for several years. Therefore since the benefit of purchasing equipment  lasts several years, accounting rules have you recognize the cost of that equipment gradually over several years (you can think of this as partial charges against your profit, as opposed to one-time big expenses).  For those of you with some business background, these partial charges are formally referred to as depreciation and/or amortization. (This relates directly to Buffett's quote above.)

2.  If you ask 99 out of 100 people:  What is the formula for calculating profit if you ran a business?  They will say... "Duh! - Revenues minus Expenses"... with a little "You think I'm stupid or something?" Well.. this is where common sense and the field of accounting depart a bit.


Let's just say you were running a successful lemonade stand in front of your home.  At the end of the month, you know how much money you collected - that is your revenue.  Similarly, at the end of each month, you know how much money you spent...however... all of that money you spent is likely NOT what accounting considers to be "expenses".  What ???... Yes ... "What"  

Since your lemonade business was doing so well, at some point you realized that you needed to buy some pots for boiling those lemons and a new stove. These pots and new stove are going to last you several years.  Since the purpose of accounting is to measure the performance of your business over several years, accounting will not count the costs of those new pots and new stove as a full expense in the year you bought them. Accounting rules will count say, just one-fifth, or one-seventh, or one-tenth of the cost of the pots and stove every year for several years as an "expense" for calculating your official (accounting) "Profit". (how much each year depends on the type of equipment purchased)

So the upshot is this - everything you need to spend money on to run a business is NOT considered an "expense" under accounting terms.  These other things you spend money on are formally called "capital expenditures".  

So think about this for a moment. Suppose you are about to invest in a business, and someone only talks about revenues and "accounting" expenses (aka EBITDA), he/she IS IGNORING all the additional money (capital expenditures) you need to spend to run the business AND IGNORING the partial charges for capital expenditures each year.  Therefore they are painting an overly rosy and misleading picture of how much money the company is really making as well as its financial strength.

This is exactly what the measure EBITDA does! It ignores a bunch of important stuff! Specifically EBITDA stands for: Earnings(Profits) Before Interest, Taxes, Depreciation, and Amortization.  EBITDA ignores all of the cash necessary for capital expenditures to successfully run a company. EBITDA ignores all of those related depreciation and amortization charges.  Similarly, EBITDA ignores interest and tax payments - additional very real cash drains.

So, once again, quoting Mr. Buffett: 

"We’ll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them."

So in summary... in business.. everything you need to spend money on is not classified as an expense.  The things you spend money on in businesses are (1) expenses and (2) capital expenditures. (For those hardcore guys, please I'm keeping it simple for what most experience > 90% of the time). If someone is talking about EBITDA, they are ignoring capital expenditures, and are therefore kidding themselves and misleading you about the health of their business.  In lieu of EBITDA a manager should talk about (1) Earnings/ Accounting Profits and (2) Cash From Operations (among other items), both of which I will save for another discussion.

So the next time you hear a company or manager talking about EBITDA, and I have heard it many a time, run the opposite way.  They will likely speak with confidence, possibly even arrogance.  Just stop and realize, that they are among those second-tier / second-rate managers that have no idea what they are talking about.  These managers are real.  They continue to exist.  Be on the lookout and certainly don't give them any of your hard-earned money.  Mr. Buffett calls them fraudsters and crooks - and I'm certainly not going to argue with him.