The Issue with EBITDA: A Case Study into Valeant Pharmaceuticals

EBITDA was created in the 1980s during the LBO boom. At the time, EBITDA was a somewhat relevant metric to acquirers who used significant leverage in purchasing a business. This is because the company's debt would be refinanced at acquisition, so the current interest payments could be ignored. Taxes were irrelevant as almost all earnings were used for interest payments. Finally, as corporate raiders had no intention of reinvesting capital back into the business, maintenance CAPEX, and by proxy, depreciation and amortization, became irrelevant as well.

After the 1980s, Wall Street stuck with its obsession with EBITDA because it produces a significantly higher number than plain earnings. Who wants to buy a company at a P/E of 44? Very few. What if the same company has an EV/EBITDA of 8? Strong buy!


Overall, EBITDA is used to mislead investors about the true nature of a business. Interest, taxes, and amortization are all expenses that need to be considered. Below we will see a case of investors turning a blind-eye to the true earnings potential of a business by relying on EBITDA.

Valeant

Valeant is a fascinating company. After a meteoric rise in price and fame that attracted notable value investors including Bill Ackman and the Sequoia Fund, the stock fell over 90%.




The metric that Valeant was famous for being measured by was “cash earnings per share”. Cash earnings per share was essentially EBITDA per share. In every investor presentation, both internally and from outside investors, only EBITDA and “cash earnings” were spoken about. In fact, below are a few slides from Bill Ackman to tell us how profitable Valeant was in 2015.

As we can see, Valeant trades at a conservative 7x earnings! Ackman now shows us both the “conservative” estimation and his estimation on the future value of the company.

To top off his presentation, Ackman even ends with a Buffet quote.

As much fun as it is to make fun of Ackman, many other investors were similarly duped into buying shares in this company. The issue lies in the fact that although the company produced incredible amounts of EBITDA, it had no GAAP profits. Because the company was being measured by a metric that excludes interest and amortization, both of which are real economic costs, the leadership did everything in their power to maximize EBITDA, at the expense of true earnings.

To illustrate how absurd ignoring depreciation and amortization is, imagine a drug (Drug A) that is recently acquired and added to a new pharmaceutical company's portfolio. Drug A provides revenues of $120 per year (with a cost to produce of $0). Our company bought the drug for $500. Under GAAP accounting rules, the acquisition cost is ignored at purchase, but amortized over the life of the patent.

As we can see (ignoring discounting), our company profited a cool $100 from the purchase of Drug A over 5 years. Now, if we use the "cash eps" metric, as Valeant did, for a second drug (Drug B), the earnings would look like this.

Our company has now earned $600 over the course of 5 years due to the magic of accounting! Although this may seem absurd, as the very real cost of acquisition is never posted, many companies use the same logic when reporting EBITDA or any other form of non-GAAP earnings. The difference is even more apparent when the cash flows are negative as shown below.

Unfortunately, Drug C was not as good of an investment as we had hoped. How can we fix this? Easy - with some non-GAAP accounting.

Our loss of $50 over the course of 5 years is now reported to shareholders as a gain of $450! This type of accounting works until it doesn't. Analysts and investors are happy to turn a blind eye to the true economic power of a company while the stock is rising, but the moment the stock begins to decline and people begin to analyse the company with more scrutiny, they will realize there is nothing justifying the stock's current valuation.

A reminder of how quickly a stock can fall when it was previously valued on made-up earnings

Conclusion

Valeant used non-GAAP accounting to fool many renowned investors. Far too many companies in the market have questionable profits backed up by non-GAAP "earnings" such as EBITDA. In order to avoid a potential trap like Valeant (and there will be many "Valeants" in the future) investors must rely on their own earnings estimates to take into account all economic costs to a business.



(Note, this article uses slides from Pershing Square. In the Copyright Act 1976, allowance is made for "fair use" of copyrighted material for purposes such as criticism, comment, news reporting, teaching, scholarship, and research.)

(Additional note, Valeant Pharmaceuticals was renamed to Bausch Health in May of 2018. The name change is interesting considering the only real reason for a company to change its name is to have consumers forget about a company's past. Considering Valeant is not a household name, the name change was intended to mislead Valeant's true customers: stock-buying investors that management hopes will pump the stock price back up.)