What's Wrong With Earnings Before...
Earnings come in a variety of flavors, based on what is included or excluded among expenses. For example, EBITDA (sometimes called cash operating profit) excludes all non-cash, non-operating expenses. With such a low cost hurdle to overcome, EBITDA growth may be a questionable proxy for value creation, especially if new assets are being acquired to generate that new EBITDA.
Consider the following pair of strategies:
Strategy A - Build a new plant costing $10 million; expect EBITDA to grow from $1 million to $2 million
Strategy B - Buy a new plant costing $25 million; expect EBITDA to grow from $1 million to $2.7 million
Let's assume that in both cases the company borrows 60 percent of the plant costs at 6 percent interest, and depreciates the plant over 20 years
Clearly, the second strategy yields much better EBIDTA growth--in fact, 70 percent better. If a company had a choice of strategy A or B, and its board was focused on and rewarded EBITDA growth, Strategy B would be the way to go. But the extra $0.7 million in EBITDA of Strategy B would cost an extra $1 million in non-cash (depreciation), non-operating (interest) expenses. In other words, Strategy A with lower EBITDA growth creates more value.
The same potential problem exists to a slightly lesser extent with respect to EBIT, Income from Operations, and other incomplete measures of earnings.
What Earnings misses
Any incomplete measure of earnings will, by definition, exclude certain costs. Consequently, a focus on EBITDA, EBIT, etc. may encourage "buying earnings" with costs that are not recognized in the measure.
Some boards decide that certain costs, particularly investment costs, are decided at the board level, and that the board would use that authority to insure that the best strategy is adopted by the firm. But this view treats the investment decision as the main step in capital budgeting. Making capital investments is, in fact, a three-step process, with management inherently controlling two of the three steps.
When it works
If you're operating a business where the excluded costs--including capital expenditures--are de minimus or unchanged over time (e.g., sunk costs), then excluding those costs would not compromise the measure as an indicator of value creation.
