EBITDA is often criticized as an imperfect measure of earnings to use broadly in comparing the profitability of companies across industries. But the concept wasn’t developed for this purpose. It was invented by billionaire investor John Malone.
Early in his career, as he began to consolidate cable systems in the 70s, John Malone realized that scale provided a tremendous advantage in cable television. The larger the company, the more leverage that company had to negotiate lower programming costs per subscriber. Since programming costs were the largest single operating expense, the largest cable operator would always have a significant advantage over the rest of the market.
Author William Thorndike elaborates on this approach and brilliantly reveals why Malone focused Wall Street’s attention on EBITDA in his book The Outsiders:
“Related to this central idea was Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.”
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“In lieu of EPS, Malone emphasized cash flow to lenders and investors, and in the process invented a new vocabulary, one that today’s managers and investors take for granted. Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges.”