NEW YORK ( TheStreet) -- Berkshire Hathaway ( BRK.A) chief Warren Buffett challenged Wall Street's most commonly used valuation metric in his annual letter to shareholders, as corporate merger and private equity buyout activity rises to levels not seen since the before the financial crisis.
Buffett criticized bankers' reliance on earnings before interest, taxes, depreciation and amortization (EBITDA) and said that the metric excludes real costs like depreciation expense. Those comments came as Buffett sought to explain the operating performance of Berkshire Hathaway subsidiaries like BNSF Railways and MidAmerican Energy, and their ability to handle debt.
"Every dime of depreciation expense we report, however, is a real cost. And that's true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet," Buffett said. In particular, Buffett said, adding back depreciation expense for businesses with long-lived assets would understate a company's costs.
Berkshire Hathaway, one of the most prolific acquirers of companies, uses different ways to calculate debt-service ratios. Instead of EBITDA, Buffett said Berkshire's definition of coverage is the company's pre-tax earnings divided by interest expense and "not EBITDA/interest, a commonly-used measure we view as seriously flawed."
At BNSF, Buffett said, pretax earnings were nine times interest expense, leading to a 9:1 coverage ratio.
Buffett did say that some of Berkshire's amortization expense may overstate the company's actual costs, especially given its acquisitive nature. When speaking about Berkshire's Manufacturing, Service and Retailing Operations, Buffett said the following:
With software, for example, amortization charges are very real expenses. Charges against other intangibles such as the amortization of customer relationships, however, arise through purchase-accounting rules and are clearly not real costs. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated -- even though from an investor's viewpoint they could not be more different.