January 12, 2006

News & Opinion: The Hot Topic in Finance

By: 800-CEO-READ @ 4:00 PM – Filed under: Current Events & Public Affairs

Yes, there are "hip" and "hot" topics in finance, including the key numbers to watch when assessing public companies. And there has been an interesting transformation over the years regarding what numbers were "hot." In the late 90's, 2000 and 2001, the key financial number everyone watched and talked about was EBITDA (earnings before interest, taxes, depreciation, and amortization). Wall Street looked for EBITDA to determine the health and potential of a company. Banks had EBITDA covenants in their corporate loan documents (some still do). EBITDA was even the hip topic of discussion at cocktail parties in the financial district.
But after the financial fraud of the late 1990s and 2000s, EBITDA is no longer the number to watch. The focus has shifted to numbers related to cash flow, with many public companies now reporting free cash flow, even though it is not a requirement to do so.
Why the change? First, Wall Street, bankers and others realized that EBITDA was easy to manipulate. Companies that were monkeying with their books simply capitalized operating expenses (expenses that normally would be charged off in the current period were instead depreciated over several years). The move made companies' EBITDA number look better, thus getting more favorable attention. Obviously, much of this constituted the fraud we have read about, and WorldCom is the poster child for fraudulent expense capitalization. Lately, EBITDA lost its position as the key number on Wall Street because it could no longer be trusted.
Second, cash is also a lot harder to fabricate than profits. Cash is what is in your bank account. That is pretty easy to verify. Investors and bankers watching over these corporations felt a bit safer looking at cash.
And finally, and maybe most important, cash is really the key element in a healthy and growing business. Warren Buffett, possibly the most successful investor, focuses on cash; and in particular on the measure he calls owner earnings. His cash-based analysis has led to 40 years of successful investing, and now Wall Street and other investors are seeing the light.
For more information about free cash flow and owner earnings, check out these sites:
You can see that The Motley Fool commented on the fact that in 2002, analysts weren't looking at it as much as they should.