If we’re going to go around quoting Warren Buffett on buying market panics like we did six months ago, it’s only fair that we also hear out the old man on the subject of depreciation.

To say that Berkshire Hathaway’s chairman is peeved about the routine discounting of depreciation as a real cost in corporate earnings reports barely scratches the depths of his disdain for the practice.

“When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak,” Buffett recently wrote in his annual letter to shareholders.

And here’s Buffett on the same topic, in the same space, two years earlier: “Depreciation charges, we want to emphasize, are different [from amortization inflated by accounting for acquisitions –IG]: Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.”

Buffett’s most detailed criticism of depreciation discounting and EBITDA came in the 2002 annual report.

“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a ‘non-cash’ charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a ‘non-cash’ expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”

The prosecution rests.

We’ll leave the defense of cash-flow accounting to Kinder Morgan (NYSE: KMI), which bought out Kinder Morgan Partners in large part so it could use the depreciation tax deferrals previously enjoyed by that MLP’s investors.

“We focus on cash flow instead of net income because we believe cash is the best gauge of underlying asset performance,” the company asserts.

“Kinder Morgan’s Distributable Cash Flow (DCF) has historically been an accurate proxy for sustainable cash flow.  The main difference between net income and DCF is net income is reduced by GAAP depreciation and DCF is reduced by sustaining capital. …There are multiple reasons why sustaining capital is more precise than GAAP depreciation.  First, sustaining capital varies greatly by the specific asset characteristics (age of pipe, pipeline diameter, amount of compression, size of compressor units, utilization of the system, number of high-consequence areas on the system, geography, historical maintenance of the pipe, and others). Second, technological advancements have significantly improved and are expected to continue to lower maintenance costs.  Third, GAAP depreciation is based on the book value of assets.  There can be a meaningful disconnect between book value and actual value of an asset depending on several factors including if an asset has been owned for a long period of time or if it was recently acquired. ”    

Note that Kinder is defending its Distributable Cash Flow (DCF) measure, not EBITDA (which stands for earnings before interest, taxes, depreciation and amortization.) Kinder argues that DCF reflects the actual cost of maintaining its asset base more accurately than its much larger depreciation charges.

But Buffett is right on the larger point: DCF doesn’t account for the up-front cost of developing that asset base. In Kinder’s case, its capital spending and cash outlays for past acquisitions are reflected mostly on its uncomfortably leveraged balance sheet, the prime culprit in December’s dividend cut.

That’s why we always look at yields and growth rates only in context with debt and distribution coverage, which are the metrics most relevant in evaluating a payout’s reliability. Anyone can grow fast or pay a fat yield for a while by borrowing unsustainably, or by selling a lot of shares. The coverage and leverage stats we share here track that toll.

What they won’t do is tally the very real cost to MLP investors of eventual depreciation recapture, assessed at ordinary income tax rates when the units are sold based on the partner’s share of depreciation reported during the holding period. The only way to dodge that hit is to hold to the grave.

But while depreciation certainly matters to investor returns, that’s not the same as saying metrics that exclude it are useless. Every value investor from Benjamin Graham to Buffett and beyond has certainly used cash flow to assess the profitability as well as liquidity of investments.

EBITDA is a terrible measure of absolute value, but it does permit rough comparisons of companies and partnerships with different tax regimes or in different industries. It’s a snapshot of underlying profitability that excludes taxes and borrowing costs, which can vary with ownership and capital structure.

There’s no question companies can misuse the measure in an attempt to cover up heavy borrowing or excessive stock-option compensation. But those are a matter of public effort for those who make the effort to read public filings (although it’s shocking how few do.)

What no earnings number or depreciation schedule can tell us on their own is how conditions will change over time.

When Boardwalk Pipeline Partners (NYSE: BWP) completed several large new pipelines in 2008-9, it had a field day selling the capacity to Texas drillers looking to move lucrative, expensive gas east and south. Eight years later, gas is so cheap no one in Texas wants to produce it, much less ship it into northern markets saturated with supply from Appalachia. Boardwalk is actually moving gas from north to south now. But while those pipelines will be around for a long time, their worth has depreciated based on changed circumstances rather than as a function of time or accounting.

As it happens, “stuff happens” is a risk Buffett knows all too well. “Charlie and I not only don’t know today what our businesses will earn next year — we don’t even know what they will earn next quarter,” he wrote in the 2002 letter. “We are suspicious of those CEOs who regularly claim they do know the future — and we become downright incredulous if they consistently reach their declared targets.”

Never let numbers, no matter how finely diced, obscure this simple truth.