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 income include:
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 replaced.
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 structure.
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 income.
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 income taxes.
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?” And in 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
March 22, 2001 (With modifications to Oct 9, 2004)