Alternative Measures of Profitability
A number of companies tend to focus on measures other than
net income as measures of profitability. Popular alternatives to net
Cash Flow, Distributable Cash Flow, Operating Income,
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and
Adjusted Net Income.
Each of these are discussed in turn.
Cash Flow has the potential to be a better measure
of performance and profitability in certain limited cases. For example when an
entire company is being purchased then the valuation is usually driven mainly by
a forecast of how much cash the business will generate over its future lifetime.
But the figure that companies usually report as cash flow
is NOT the free cash flow that could be taken out of the business and is not
usually a particularly useful number at all.
When companies discuss "Cash Flow" they usually mean cash generated from operations. That is, cash
from selling products and services less operating expenses. Cash Flow from
operations is shown on the Statement of Cash Flow and is calculated as Net
income plus or minus "items not affecting cash".
In most cases Cash Flow is net income plus depreciation and
amortization and plus deferred income taxes. Effectively then it is net income before
deducting a depreciation
or amortization expense and before deducting income taxes which were expensed for accounting
purposes but which are not actually payable or owing (yet) due to timing differences between
accounting rules and tax rules. All of these are non-cash expenses.
If assets are not in fact deteriorating and wearing out,
then this measure of Cash Flow might be better than accounting net income as a measure of economic earnings.
(Since the accounting depreciation expense implicitly assumes that assets are
wearing out and will have to be replaced).
However, in most cases the assets are in fact wearing out
and depreciation is a very real expense. For most asset intensive industries like manufacturers,
railways, and (to a lesser extent) cable and telephone companies, depreciation
and/or obsolescence is a very real phenomena and
Cash Flow from operations is of no use in measuring performance.
To illustrate the difference between cash flow and net
income, I recently calculated the value of two projects. The first
involved an asset that had to be replaced each year. In this case net income was
equal to free cash flow. The second project was similar but the productive asset
would last 30 years before being replaced. In this case, net income would
under-state free cash flow generation. At a 10% discount rate, the first project
could justify a P/E of 10, while the second could justify a P/E of 13.7. Due to
the non-cash nature of depreciation, the asset that lasted for 30 years, was
worth about 35% more than was suggested by the earnings alone. The solution in
the case of an asset that does not have to be replaced for 30 years is to add
back the depreciation and treat it as additional earnings.
However, investors should be very cautious before treating
depreciation as a non-cash item. In almost all real cases companies do need some
capital spending just to maintain current operations. For example, apartment
towers last a very long time, but carpets and appliances still need to be
In some cases unrealized gains on assets may be expected to
occur at a rate that effectively "cancels out" depreciation expense.
For example in housing and real estate there is no doubt that older buildings
deteriorate and become obsolescent and are not as valuable as an equivalent new
building. However, many buildings in popular areas will hold their value or
appreciate in value due to their locations. For this reason, real estate
companies argue that Cash Flow is a more valid measure of performance than net income.
However since such appreciation in building and home values may not occur in the
future, I am
hesitant to accept this logic. And, if a building's value has increased, then its rent
should also have increased and the value should show up in higher net
income. In fact, the real estate industry uses a decelerated form of
depreciation called the sinking fund method. This method attempts to recognize that a newer building may depreciate slowly at first and then more quickly in
later years. In view of this lower level of depreciation, I cannot
agree that ignoring depreciation, makes sense. However, the main
building structure will not need to be replaced for many many years. Even after
inflation there is a benefit to the deferral of this expense. To deal with this, a
certain percentage of the accounting depreciation could be added back to net
income to recognize the value of the deferral of the replacement of the building
In regards to deferred taxes, this amount is expected to
eventually reverse and so I can't completely support treating it as if it were not an
expense. But it is true that a deferral of taxes is a benefit compared to paying
the tax immediately. For example is taxes are deferred for five years on average
then, on a present value basis, this is equivalent to a reduction in taxes. The
best way to deal with this would be to add back to net income a portion of the
deferred taxes that represents the reduction of the liability on a present value
basis. Sadly, GAAP does not require the deferred taxes to be disclosed on a
present value basis nor does management disclose how many years the deferral
lasts on average.
Technically, Cash Flow from operations also includes
"changes in non-cash working capital balances". Working capital means
all current assets and liabilities other than cash. If a company increases its
short term liabilities, by not paying its bills, then its Cash Flow will
increase. This manner of increasing Cash Flow is clearly a form of borrowing
(albeit usually interest free) and
is not a form of income. For that reason, when companies talk about Cash Flow
from Operations, they usually mean Cash Flow before the changes in working
capital. Most Cash Flow Statements provide this as a subtotal. In cases where
investments in working capital are increasing steadily with growth, it may make
sense to use this definition of cash flow. But obtaining an increase in cash
flow by decreasing working capital is not likely a sustainable source of cash.
In summary, Cash Flow from operations is usually of no use
as a substitute for net income. This is particularly the case in industries with
a heavy depreciation expense and where it is clear that assets actually are
wearing out and are being replaced on a constant basis. I generally ignore Cash Flow and start with net
income. I can then adjust net income for any goodwill amortizations that are not real
expenses and for deferrals of expenses and for true one-time items. This is discussed below.
If management does want to focus on Cash Flow, then they
also should discuss how much of the Cash has to be reinvested in capital assets
in order to sustain the business. Companies do report capital investments but
they almost never separate out these investments into those that that are needed
to sustain current operations and those that represent investments to create
growth. Operating Cash Flow less sustaining capital investments is called Free
Cash Flow and may be a reasonable substitute for net income. The problem is that
companies seldom report such Free Cash Flow.
Distributable Cash Flow
Distributable Cash Flow has recently become very popular in
Canada as a substitute for earnings. Income Trusts rely on this measure.
Essentially it is a view of free cash flow. As indicated in the Cash Flow
discussion above there may be cases where distributable cash flow legitimately
and systematically exceeds net income. But I think investors have to be very
cautious. There is no GAAP definition of distributable cash flow. Many companies
and Trusts may be under-estimating capital spending needs. The concept of
distributable cash flow effectively "thumbs its nose" at GAAP net earnings. A
few years ago many companies did that by focusing on EBITDA and in most cases it
turned out that the GAAP net income was closer to reality.
Operating income is income before costs for interest and income taxes and before non-operating income such as income from
investments in other companies.
Operating income may be important when analyzing if a
company is earning enough to stay in business and avoid insolvency. It is also
of interest to bond investors and other lenders since they need to know how much
operating income is available to pay interest on bonds. It can also be useful in understanding and
analyzing why one company is more or less profitable than another.
However, it is certainly no substitute for net income. How
could it be, when it is before such very real expenses as interest costs and
income taxes? Equity investors get their return from net income after interest
and income taxes.
What I find most aggravating about operating income is that
it looks and sounds a lot like net income. It simply infuriates me when I see a
company give top billing to operating income while leaving disclosure of net
income (or more typically net loss) to the smaller print. Many novice investors
and non-accountants are likely to be misled by such practices.
In assessing the profitability of a company, as an equity
investor, I ignore
operating income in favor of net income or, where applicable, adjusted net
EBITDA - Earnings Before Interest, Taxes,
Depreciation and Amortization
This one is a real howler! An oxymoron if there ever was
one, "Earnings" before interest, taxes, depreciation and
amortization. In essence earnings before asset related expenses and before
EBITDA arguably has some uses in comparing one company to
another and in understanding all the components and steps in arriving at net
income. And it is of interest to bond investors and lenders. But many managements seem to completely mis-understand the concept and
present it as a substitute for net income.
It might be somewhat interesting to know that a certain
company would have been nicely profitable if not for those pesky asset
related expenses. But as an equity investor, I don't care about EBITDA, I care
about the bottom line, net income.
Whenever a company talks about EBITDA, I consider it a real
danger signal. Usually it means the company is not earning enough net income,
and they would like to deflect attention away from that fact. Even worse it can signal that management does not even understand that
its job is to generate net income.
In his 2000 letter to his shareholders legendary investor
Warren Buffett states "References to EBITDA make us shudder - does
management think that the tooth fairy pays for capital expenditures?"
his publication called "An Owner's Manual" he states that that, with rare exception,
depreciation is a very real expense and that "Managements that dismiss the
importance of depreciation - and emphasize 'cash flow' or EBITDA - are apt to
make faulty decisions".
Enough said, the legend has spoken, let us learn.
Adjusted Net Income
At first thought you might tend to also be very
suspect of any management that talks about net income before various unusual
events. You might feel that net income is the bottom line and the company should live
and die by its actual net income. After all, shouldn't a company be punished in
some way for an unusual loss or write-down? Why should you ignore it in favor of
some adjusted net income?
However, experience and reflection reveal the merits
of adjusted net income. When we look at net income, we are most interested in knowing
what it tells us about future net income. If we adjust and "normalize"
the net income for any unusual items, then we arrive at a more representative
and (presumably) sustainable level of net income. It is this sustainable net
income per share which is most useful in calculating the value of a share in a company.
Fortunately, in a great many cases management provides a
figure for adjusted net income which adds back amortization of goodwill and
reverses the impact of various one-time or unusual events. If management does
this then it can often be the most representative view of the true economic net
income. Unfortunately, many other companies do not provide these figures even
when there are major one-time impacts. In the worse cases, management will tend
to add back unusual expenses but fail to subtract the unusual gains. So, one has to be cautious.
For some industries it may also be appropriate to add back
a portion of deferred taxes and depreciation on very long lived assets to
reflect the present value benefit of the deferral.
Of course, some companies may abuse the notion of adjusted
net income and start adding back expenses that are really not one-time costs.
In summary the concept of an adjusted net income is a very
useful concept and is a figure that should generally be used in evaluating a
company. Free cash flow is also a valuable figure, but is seldom provided
by companies. The other substitutes for net income such as operating income, so
called cash flow (operating cash flow) and EBITDA are in fact no substitute at all for net income and should
not be used in place of net income.
Shawn Allen, CFA, CMA, MBA, P.Eng.
Editor and President
22, 2001 (With modifications to Oct 9, 2004)