Adjusted EBITDA is bad for your health

If you’re an investor, adjusted EBITDA is bad for you because the company is trying to say “don’t count these things when you decide what we’re worth.” Usually, those things are actual cash expenses, and because we all know that the discounted sum of all future cash flows IS the value of the company, when cash items are adjusted away, you get a distorted view.

What are some common adjustments? In the startup world, I see companies wanting to adjust their EBITDA for marketing expenses. The argument is that those expenses are discretionary, and so they could be returned to the shareholders as dividends or just increased FCF to the business. You know what I’ve never seen? A company adjust away their marketing expenses and then similarly adjust away the revenue they got from those marketing expenses.

That approach – we could market less, so consider us differently, isn’t entirely crazy except when it is. Looking backwards, it is crazy. Looking backwards and pretending growth won’t change going forwards is crazy too. Looking forwards and saying here are two alternate plans we could adopt – lots of marketing and a lot less marketing – isn’t crazy. Identifying the tradeoffs from reduced marketing expense and perhaps lower capital intensity is just good planning. Valuing the two alternatives is what management and the board have to do to make a decision of how to proceed.

But that’s not adjusting EBITDA: it’s tactical planning for how to execute the company’s strategy, and it pretty much is only here to highlight why pretending the past didn’t happen through adjusted EBITDA doesn’t work.

When I see public companies use adjusted EBITDA, it means that they see that the market is unhappy with the way they’re running the business and thus they say, “See? We could totally have done this, which is much better.” But they didn’t. They *chose* to run the company in the way they did.

They might as well say adjusted revenue – “we could have raised prices and made more money” – but they didn’t do that either.

We instinctively recoil against that because the law of supply and demand tells us that for most goods, there’s elasticity in price, and increased price typically means decreased volume. Whether that means more revenue or not depends on the specific shape of the demand curve over the relevant interval, but we all know this: there’s a tradeoff, and if you only show the good side of the tradeoff, we can all call BS.

The same is true with adjusted EBITDA, particularly when it’s something like marketing where the tradeoff is also obvious.

As an analogy, it’s not at all uncommon when calculating ROIC for a company for equity analysts to remove “excess cash” from the balance sheet because the company “could” dividend it out. But they didn’t. Pretending that a company like Apple isn’t sitting on $190 billion of cash and investments might be good, but we can all agree that pretending doesn’t make it true. Apple is using that capital. It’s not invested elsewhere in some other business.

So, what’s the real lesson? If you’re a private company, and you start using adjusted EBITDA, who’s that for? Who are you trying to convince that the past didn’t happen? When a startup spends a lot of money to acquire customers because they don’t have product-market fit, it’s one thing to *plan* for a better performance next year, and another entirely to pretend that you ran the race faster than you did. Could you imagine the Olympics with the world record holder losing to someone else? “My adjusted time in the marathon is 2:04, so I really won, when you think about it.”

So, if you’re a private company, I urge you to consider if using adjusted EBITDA is a way to avoid having the hard conversation of “why didn’t we accomplish what we planned?” And if you don’t have a plan, and don’t manage to plan, I can give you a multiple choice: three guesses and the first two don’t count.