Who Invented EBITDA?

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.

If you are unfamiliar with John Malone, the two most important things to know about him for the purpose of this post are as follows. First, he is incredibly good at buying cable systems:

“Few people have made more money for investors over the past three decades than John Malone. The billionaire cable-TV investor and operator parlayed a small group of cable systems, originally assembled in the 1970s, into Tele-Communications Inc., before selling it to AT&T in 1999 for $48 billion.” [1]

And second, he is excellent at avoiding taxes:

“No other executive in the U.S. has mastered the intricacies of the tax code to the same extent that Malone has,” says New York tax expert Robert Willens. “We are consistently in awe of the structures he and his advisors come up with to rearrange his extensive holdings, always without tax consequences, in the most advantageous way.” [2]

Early in his career, as he began to consolidate cable systems in the 70s, 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.”

“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.” [3]

Throughout the text Thorndike emphasizes how unconventional this approach was, but it is by no means the first time new metrics or language have been introduced to support valuation. The oldest example is perhaps that of putting the word “trading” before “sardine” as Seth Klarman describes in Margin of Safety:

“There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.” [4]

And you don’t have to go that far back in time for equally inappropriate examples. In 2000 “eyeballs” could be monetized (right up until they couldn’t). EBITDA, in this context, may just be the most appropriate invented metric to withstand the test of time. Before his competitors adopted it’s use, Malone developed an advantage over the rest of the market by getting investors and lenders to focus on this figure over net income. Today it is an industry standard, but hopefully this origin story will motivate readers to evaluate EBITDA with the suspicion it deserves when offered as a proxy for cash flow.

[1] Liberty Media: Better than Berkshire
[2] Liberty Media: Better than Berkshire
[3] Thorndike, William The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, p. 91
[4] Klarman, Seth Margin of Safety, p. 5