Net Income May Not Be The Best Way To Measure All CompaniesNet Income May Not Be The Best Way To Measure All Companies

Over the last few years, it's become clear that many technology investors don't know how to value companies that have negative net income. For example, what's the best way to look at an emerging telecom company that's building out its network and accruing lots of debt? Net income, when calculated according to U.S. Generally Accepted Accounting Principles, can be distorted and tell an investor little about the operations. As substitute, EBITDA is a metric that's often presented as a surrogate for cash flow from operations. EBITDA is short for earnings before interest, tax, depreciation, and amortization expenses. All these expense items are simply ignored, whereas net income includes them.

Cable operators such as Comcast and Cox often use EBITDA, as do telecoms such as Qwest and McLeod USA. The basic reason for using this method is that the company being analyzed is early in its life cycle and is spending heavily on building out its infrastructure (a cable network, for example). Current capital expenditures are therefore at a very high level--much higher than one would expect them to be once the business matures and is self-sustaining. In theory, capital equipment such as a cable network will wear down over time, therefore decreasing its value. This is called depreciation.

Depreciation expense is an accountant's way of allocating capital across time to more closely align with the timing of revenue generated by those assets. For mature companies, depreciation is basically equal to the capital needed to maintain the value of that asset. But a young company that's spent heavily up front on a network won't be required to spend much on maintaining its value. This means depreciation will be greater than the maintenance capital expenditure, distorting earnings.

To build a new telecom network or cable infrastructure, most carriers and cable companies have taken on a mountain of debt. As a consequence, interest expense is high. Ultimately, companies expect to pay down the debt rapidly once operating cash flow comes rolling in. Thus, the "normal" interest expense level eventually will be quite a bit lower. The end result is that EBITDA might provide a rough proxy for what the company would earn on an ongoing basis when it matures. By using EBITDA, you aren't penalizing the company for the high interest and depreciation items associated with a fast-growing business.

What about a software company that acquired another company last year and whose net income is negative because of the amortization of the goodwill recorded in the transaction? Amortization, for accounting purposes, behaves much like depreciation but on soft assets such as intellectual property or brand-name values that are assumed to have finite lives. Instead of using net income, one could look at EBITDA, which ignores amortization, thereby presenting the company in a more flattering light. However, it's possible that an investor isn't accounting for the true cost of the acquisition correctly if amortization is ignored. Upcoming changes in the way acquisitions and mergers will be accounted for will make for even greater confusion, at least initially.

Some of the confusion will come from restatements of the financial results and the lack of historical financials presented on an apples-to-apples basis. What you really need to ask yourself is whether EBITDA provides you with any analytical insight about a business. Sometimes it does--but most of the time I still resort to looking at cash flow from operations and free cash flow. EBITDA is neither. It ignores important expenses such as interest expense and taxes, both real cash expenses. EBITDA also doesn't account for working capital needs such as cash spent on inventory or the lack of cash from accounts receivable not being collected. To get to free cash flow, the cost of maintaining a company's plant in operational condition must also be deducted.

I suspect that the new accounting rules, combined with the usual plethora of accounting tricks (such as one-time charges and R&D write-offs), will keep me busy for years to come.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the information 100 Stock Index. Reach him at [email protected].