From 19-year-old business majors to partners at Goldman, nearly everyone with experience in finance is familiar with the term EBITDA. Seen as a proxy for cash flow, it has been the go-to profitability metric for Wall Street for numerous decades.

But it wasn’t always this way.

Earnings per share used to be the gold standard on the street before an ambitious lad with a passion for engineering and entrepreneurship changed the measuring stick.

John C. Malone was born in Milford, Connecticut in 1941, and it didn’t take him very long to venture into entrepreneurship, as he began to buy, refurbish, and sell used radios as a teenager. A few years later, he enrolled at Yale, studying economics and electrical engineering.

After graduating, he accepted a position at Bell Labs, the prestigious research arm of AT&T, where he analyzed optimal strategies in monopolistic markets and made suggestions when appropriate.

Eventually he concluded that AT&T needed to add two items to their agenda: (a) take on more debt and (b) strategically repurchase its shares. To Malone’s surprise, his advice was ignored.

This specific situation—which highlighted the bureaucratic nature of AT&T—drove Malone to search for employment elsewhere.

More on AT&T later…

After his departure, he landed at McKinsey which had just began to build out its new tech group.

General Instrument, one of McKinsey’s clients, was having trouble with its latest acquisition Jerrold Electronics, a company that built and financed cable systems. Malone had never paid much attention to the cable industry, but after working with General Instrument, the sector immediately piqued his attention for three reasons: high quality (recurring and sticky) revenue, minimal competition due to receiving local monopolies from cable franchises, and favorable tax characteristics.

The cherry on top was that it was a fast-growing industry with no signs of slowing down: subscriber numbers increased 20x from the 1960s to the 1970s.

After spending some time formulating his plan for Jerrold, he met with General Instrument’s management and laid out the blueprint.

The idea and steps on how to execute it were so impressive that General Instrument offered him Jerrold’s CEO position.

After a short stint at Jerrold, he was offered the chief executive spot at two different prestigious firms: Warner Communications and Tele-Communications Inc (TCI). Despite TCI’s salary being 60% lower than Warner’s offer, Malone went with TCI due to the larger equity stake and his wife’s preference for Denver’s serenity relative to Manhattan.

Malone’s start at TCI wasn’t so hot.

TCI had gone public a few years prior, and the company was planning a follow-on equity offering given attractive valuations in the telecom market. Seemingly out of nowhere, the industry was hit with a wave of new regulations and the market suddenly cooled.

Malone & Co. now had to cancel the offering, which was especially bad news given the capital was going to be used to pay down their increasing debt load; now, without the capital, the company was teetering on the edge of bankruptcy.

After a short stint flirting with potential liquidation, Malone was eventually able to right the ship. During these years, Malone began formulating a plan that would not only enrich himself and his investors but also leave an indelible mark on the financial services industry.

Malone realized that maximizing earnings per share, the most important metric for public companies at the time, didn’t match his visions for scaling. For him, higher net income only meant one thing in his mind: a higher tax burden.

If there was one thing that John Malone hated more than anything, it was paying taxes. His libertarian attitude drove him to search for the most creative ways to decrease his tax load. More specifically, he was looking for a way to minimize reported earnings, and therefore taxes, while funding internal growth and acquisitions with pretax cash flow.

The method he used to accomplish this was his brainchild EBITDA, earnings before interest, taxes, depreciation, and amortization.

Technically speaking, Malone didn’t create the term our of thin air—the 1966 textbook The Economics of Corporate Finance labeled the term first, but Malone was the first to actually use it.

Going upstream on the income statement to EBITDA, rather than net income, presented the perfect solution for Malone. The capital intensive nature of the industry lead to high depreciation costs. Combine this with Malone’s aggressive use of debt / large interest payments, and EBITDA enabled him to signal profitability while minimizing his tax expense.

The next step for him was to convince banks to use the metric for loan covenants, and after doing so, the rest was history.

Malone consistently aimed for a 5x debt to EBITDA ratio, and when acquiring other companies, would never pay more than 5x cash flow. Besides using debt to shelter TCI’s cash flow from taxes through the deduction of interest payments, Malone also utilized it to magnify his and his investors’ return.

He also identified that economies of scale, specifically within the cable industry, provided a massive advantage. The larger the company, the more leverage it had to negotiate lower programming costs per subscriber with programmers like HBO, ESPN, MTV, and others. This was crucial given these programming costs were the largest operating expense, clocking in at roughly 40%.

Because of this, Malone militantly acquired companies, both small and large. Between 1973 and 1989, the company closed 482 acquisitions, roughly one every other week.

Malone’s new formula seemed to have cracked the code: use EBITDA instead of EPS, aggressively depreciate, pay less taxes, show bankers profitability, use that profitability to take on more debt, use that debt for acquisitions, grow, and repeat.

As Malone’s success continued to grow, so did the popularity of EBITDA, as Wall Street began to adopt it, specifically in the leveraged buyout era in the 1980s.

But not everyone was a fan.

Warren Buffett first wrote disapprovingly of EBITDA in 1989 in his annual letter to shareholders, calling it “an abomination.” In his eyes, the attitude of ignoring depreciation as an expense because it doesn’t require an immediate cash outlay was “delusional.”

Nowadays, he allegedly “shudders” at the mere mention of EBITDA. His former colleague and business partner Charlie Munger echoes a similar statement saying, “I think you would understand any presentation using the word EBITDA, if every time you saw that word, you just substituted the phrase BS earnings.”

Nevertheless, Malone, and the rest of the financial world, continued to use EBITDA and saw his success continually increase.

However, by the early 1990s, Malone knew that it made more sense to sell, rather than hold, despite his love for the cable business. It came down to three factors: rising competition from satellite TV, the high cost of upgrading the company’s rural systems, and uncertainty about management.

He soon began acquisition talks with AT&T’s new CEO Mike Armstrong. Malone allegedly did all negotiations himself, facing off against AT&T’s management, lawyers, bankers, and accountants.

After lengthy discussions, the company was sold for $48B (12x EBITDA), which was nearly $2,600 per subscriber.

True to his nature, he structured the transaction to allow his investors to defer capital gains taxes.

The compound annual return for TCI shareholders was 30.3%, far surpassing the industry average of 20.4% and 14.3% S&P return.

Besides his ingenious use of EBITDA, Malone was known for only issuing equity when multiples were abnormally high, never paying dividends, repurchasing shares during market downturns, utilizing cost reduction methods post-acquisition like cutting payroll in half and moving from fancy headquarters to low cost industrial buildings, and, of course, (legally) evading taxes.

In fact, the only thing that Malone would spend money lavishly on was his in-house tax savants.

Acclaimed NY tax expert Robert Willens asserted that “no other executive in the US has mastered the intricacies of the tax code to the same extent that Malone has.”

Despite having never worked in banking or a buy-side shop, Malone’s impact on Wall Street cannot be understated. He was able to generate impressive returns for his investors regardless of his lackluster EPS numbers, redefining how analysts treat cash flow in the process.

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