When you’re deciding where to invest your money, getting a clear picture of a company’s true profitability is essential. Warren Buffett, one of the most successful investors of all time, recommends focusing on EBIT (Earnings Before Interest and Taxes) instead of EBITDA. While EBITDA can make a company look more profitable by leaving out certain costs, EBIT includes depreciation, which shows the real expenses a business faces to maintain its assets. This is especially important for companies that spend a lot on equipment, buildings, or other long-term investments. By paying attention to EBIT, Buffett ensures he understands the true financial health of a business, avoiding the pitfalls of seemingly strong numbers that might hide underlying costs. In this article, we’ll dive into why Buffett prefers EBIT over EBITDA and how this approach can help you make smarter investment choices.

1. Buffett’s General View on “Ignoring Depreciation”

Warren Buffett is famously critical of metrics that exclude depreciation and amortization (such as EBITDA). He has joked about EBITDA by asking something along the lines of, “Do managements think the tooth fairy pays for capital expenditures?” This remark underscores that ignoring depreciation (a cost that will eventually show up as cash outflow for maintenance capex) can be misleading when determining a company’s true economic profit.

In a traditional manufacturing or capital-heavy business, physical assets (e.g., machinery, plants, equipment) deteriorate over time. To keep a business running smoothly, one must repair or replace these assets. Depreciation is simply the accounting measure of “spreading out” that cost over the useful life of the asset. If you pretend depreciation doesn’t exist (by using EBITDA), you might overestimate how much cash flow the company has to pay dividends, service debt, or reinvest in growth.

2. Depreciation Ties to Real Maintenance Capex

One of the big reasons Buffett focuses on EBIT rather than EBITDA is that depreciation generally represents a real economic cost over time. Even though depreciation is non-cash in any given quarter, eventually that “non-cash” expense turns into a cash outlay when you have to fix or replace the asset.

In other words, depreciation tracks (albeit imperfectly) the ongoing wear and tear of tangible capital. If you operate a steel mill, you cannot run your furnaces forever without maintenance and replacement; if you’re an airline, you eventually must replace planes; if you’re in telecom, you must update towers and switches. This is why Buffett (who invests in many capital-intensive or infrastructure-related businesses) tends to watch EBIT—because EBIT acknowledges that depreciation is part of the cost of doing business.

3. The Fallacy of “EBITDA as Cash Flow”

People who favor EBITDA sometimes label it a “proxy for cash flow.” Buffett disagrees—especially for capital-intensive companies—because calling EBITDA a measure of “cash flow” overlooks the fact that, in the long run, capital expenditures (capex) to replace depreciating assets can eat up a large chunk of that “cash.”

Even in the best of times, if a company must constantly spend nearly the same amount as its annual depreciation in maintenance capex, the real free cash flow is much lower than the headline EBITDA number suggests. Buffett wants to understand how much money is actually left after paying all costs necessary to keep the business running, which includes upkeep and replacement of critical assets.

4. Why EBIT Is More Aligned with Buffett’s Thinking

EBIT (Earnings Before Interest and Taxes) deducts depreciation and amortization, thus giving a clearer sense of how profitable the business is after considering the ongoing wear-and-tear of tangible (and sometimes intangible) assets. Although EBIT is still an accounting metric (and you’d want to look at actual capital expenditures, too), it’s closer to the economic reality of capital-intensive firms.

Buffett’s argument is that if a business truly must spend money to repair, replace, or upgrade assets on a regular basis, ignoring depreciation is akin to ignoring part of its essential cost structure. EBIT, while not perfect, at least reminds investors that depreciation is there and accounts for the fact that machines, trucks, planes—whatever the assets—don’t last forever.

5. The Core Principle: Maintenance Capex Is Real

Ultimately, Buffett’s takeaway is that depreciation is not some imaginary line on the income statement. Even if intangible amortization can sometimes be fuzzy, tangible depreciation is typically quite real. In the long run, it shows up as maintenance capex. Many companies tout “record EBITDA,” but if they require a hefty reinvestment cycle just to keep the lights on, those reported “profits” don’t translate to free cash flow or dividend capacity.

Therefore, Buffett and many like-minded value investors lean on EBIT (and, better yet, Free Cash Flow) to see how much profit remains after factoring in the cost of sustaining assets. Ignoring that cost is a bit like ignoring rent payments when calculating your personal monthly budget—sooner or later, the real cost becomes unavoidable.

6. Concluding the Argument

• Buffett’s “Tooth Fairy” Quote: He’s essentially saying that managers who tout EBITDA as a proxy for real profit are glossing over the inevitable cash drain that comes from capital expenditures.
• Look at EBIT (and FCF): By including depreciation, EBIT reminds you that assets wear out. Even better is to examine free cash flow, which factors in actual maintenance capex spending.
• Capital Intensity Matters: In highly capital-intensive businesses, ignoring depreciation can drastically overstate a company’s sustainable earnings power.

In summary, Buffett’s stance is that while EBITDA can be a useful comparative metric in certain contexts (e.g., for very asset-light companies or quick, high-level screening), most real-world businesses cannot ignore depreciation. That’s why he advocates looking at EBIT and, more fundamentally, free cash flow—because depreciation, or the need for maintenance capex, will consume cash in the long run.