03 October 2017
Letter to the Editors
from Anthony Silver
In the ultimate para of his article on the late Thos. Cook, Frank O’Nomics made the important point that shareholders need be mindful of ‘…level of debt on the balance sheet, the cost of servicing that debt, and the extent to which efforts are being made to pay it down.’
Being a child of the 60’s and serving my banking apprenticeship in the 80’s, two of the most important touchstones of corporate health then were ‘interest cover’ (the ratio of profit over interest payments) and ‘price/earnings’- earnings being defined as profit after tax but excluding one off gains/losses. Earnings lost favour in the 90’s with the rise in popularity of Ebitda, (earnings before interest, tax, depreciation + amortisation), probably because in an era of high interest rates, earnings become compromised (so lets ignore the problem!?).
For at least one decade I railed against the substitution of Ebitda for earnings, arguing that although operating cash flow is an important measure, if you discount the effect of debt (interest) in earnings then the only barrier to a company loading up on debt is its lenders (who are of course conflicted). Obviously it is a nonsense to value two companies producing £50m profit the same when one is carrying a burden of £400m debt and the other only has £30m. This is what using the Ebitda ratio will do.
So defensive investors may want to consider using the earnings figure when evaluating their next share purchase.