nonoperational changes between reporting periods, it may be diffi-
cult to develop a reasonable estimation of future growth trends.
With core earnings adjustments, the values being studied are isolat-
ed to only those items we can expect to recur.
Long-Term Direction in Corporate Valuation
In our post-Enron investing environment, we may expect to see new
trends both in how investing works and in how corporations report
their results. Even the structure of the market itself is under review
in the spirit of reform and reevaluation.
The New York Stock Exchange, for example, has traditionally
been viewed uncritically as the most important trading center in the
United States. The lower costs and less formal rules associated with the
NASDAQ have put the NYSE under scrutiny. Today, the role of the
exchange—and of all exchanges, for that matter—has merged from the
relatively simple exchange functions into a combined exchange-and-
regulatory function. The exchanges have a duty to regulate member
companies, and through listing standards and enforcement of federal
and state laws, the exchanges are beginning to take a more active and
aggressive role in enacting and enforcing rules.
In this changed market environment, not only are the exchanges
undergoing change, but planners and analysts are also taking a new
look at the very assumptions used in making important financial
decisions. The use of core earnings is perhaps the most significant
step in this new trend; but at the same time, older methods are com-
ing under question as well. For example, it was assumed for many
years that the calculation of Earnings Before Interest, Taxes, De-
preciation and Amortization (EBITDA) was a valid method for iden-
tifying cash-based results for companies. This assumption is
questionable, and we now realize that it is very inaccurate.
The most vigorous attempts at placing a fair valuation on a stock
investment may be elusive and difficult for even the most skilled an-
alyst. In the past, EBITDA was recognized by many analysts, ac-
countants, and investors as a necessary adjustment to arrive at a
reasonable definition of cash-based profit (cash flow versus earn-
ings). The intention under EBITDA was a good one: remove the
nonoperational expenses (interest and taxes) and add back the non-
cash expenses (depreciation and amortization), and the result will be
a realistic cash-based, true operating net income number.
The problem, of course, is that EBITDA begins with some flawed
assumptions. First of all, there is far more to what is included in
“earnings from operations” than as calculated under the EBITDA
system. The pro forma income from profit-sharing investments, un-
expensed employee stock options, capital gains or losses, reversal or
reserves for acquisitions, and other possible core earnings adjust-
ments all have a significant effect on earnings and still pass through
the EBITDA formula untouched. Secondly, the adjustments made for
amortization and depreciation do not place revenues on a truly cash
basis. In any review of working capital, it becomes evident that a
massive shift in inventory, accounts receivable, accounts payable, and
other current assets or liabilities also have a significant impact on
earnings. For example, a change in assumption concerning bad debt
reserve or inventory loss reserves may easily alter reported earnings.
Key Point: EBITDA served a useful purpose in the past in
some respects. Under the current environment, though, it is
of no real value.
Originally developed to enable analysts to review corporate earn-
ings on a like-kind basis, EBITDA is now recognized as a deeply
flawed system. The accounting adjustments that are allowed under
GAAP make EBITDA less than adequate to create a fair reporting
system. For example, in 2002, WorldCom disclosed that it had

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