Investors should use a variety of tools for understanding a company’s valuation before buying its stock.
One of those valuation measurements is called EBITDA, an acronym for “earnings before interest, taxes, depreciation and amortization.”
While it shouldn’t be used alone, EBITDA can provide investors with an idea of a company’s cash flows before certain expenses and offers an idea of whether a company is headed in the right direction from a financial standpoint. It also makes it easier to compare two companies within the same industry when deciding which stock to buy.
“EBITDA helps level the playing field when comparing two companies,” says Peter Davies, CEO at Jigsaw Trading. “Think of it as filtering out a little financial noise.”
Here’s a breakdown of what EBITDA means and why this measurement is important to understand as a valuation metric for investing:
— What is EBITDA?
— Who uses EBITDA?
— What is a good EBITDA?
— Why use EBITDA?
— The cons of EBITDA.
— EBITDA versus net income.
What Is EBITDA?
EBITDA is an investment term used to measure a company’s operating and financial performance and profitability by reviewing its income statements.
Earnings are a company’s total sales minus all its expenses. Expenses include taxes, interests, depreciation and amortization — and including some expenses can skew the picture of a company’s overall profitability.
The letter “B” stands for before, and it’s there to show items that are excluded from the operational performance measurement. Interest, taxes, depreciation and amortization are all excluded since they do not affect the company’s operating performance.
Interest is a core expense that can be found on an income statement that results from financing a company’s debt. This metric can also be calculated through a debt schedule that lists out all the debt a company has on its balance sheet. Interest is excluded from EBITDA because company capital structures vary and thus each has different interest expenses.
Taxes are also excluded from EBITDA since this expense differs depending on geography and doesn’t really have anything to do with a company’s performance. Interest and taxes are removed to provide the investor with a clearer picture of the company’s true financial performance.
Depreciation and amortization are non-cash expenses and do not directly influence a company’s operating income, explaining why these metrics are removed as well. Depreciation is the loss of an asset over a period of time.
Amortization refers to paying off debt over the life of an asset. Both metrics may reduce profits but do not impact cash flows. And since EBITDA is concerned with calculating a company’s cash flow, it’s more effective to eliminate them from the calculation to better determine a company’s value.
“If used correctly, (EBITDA) can provide a clearer view into a company’s earnings and how well it’s able to manage its resources,” says Ronald Samson, research analyst at CreditDonkey.
Again, with EBITDA, interest, taxes, depreciation and amortization are all excluded because they do not affect a company’s operating performance, giving a clearer picture of operating cash flow.
There are two ways of calculating EBITDA:
1. Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA
2. Operating Profit + Depreciation + Amortization = EBITDA
Who Uses EBITDA?
Finance professionals use EBITDA to understand how profitable a company is — but retail investors can also easily learn this calculation to help them with the valuation of a prospective investment before adding it to their portfolio.
A company’s management team will often use EBITDA to give a view into the company’s value and demonstrate its worth for prospective investors.
Banks turn to EBITDA because it gives them a picture of a business’ ability to pay back loans.
Financial analysts also use the calculation to find what really drives value for a company and to forecast the company’s future profits.
Investment bankers often use EBITDA to remove the influence of financing and accounting decisions on operating performance, allowing them to better gauge the company’s ability to service debt and increase top-line revenue and/or operating efficiency, says Theodore Schneider, director and portfolio advisor with Round Table Wealth Management.
It can also be used to help value private companies that do not have a trading stock price to help determine their valuation, he adds.
What Is a Good EBITDA?
You may not want to think about whether an EBITDA number is good or bad. Rather, EBITDA can be helpful as a relative gauge for comparing companies. A company’s EBITDA might be great compared with its peers, but might not look so good compared with companies in other industries.
EBITDA is often used in combination with enterprise value to create an EV/EBITDA multiple.
That and other multiples like price-to-earnings and price-to-sales “can be used to compare valuation between companies in the prevailing market conditions,” says John O’Connor, vice president and senior analyst at RMB Capital. “If valuations are rich for all companies, multiples can be used to determine which companies are relatively less richly valued.”
One way investors use EBITDA is to divide it by a company’s revenue to calculate EBITDA margin. A good EBITDA margin is one that is high in general but also higher than its peers.
A high EBITDA margin tells the investor that a company has strong cash flow and the business is likely to be profitable.
Why Use EBITDA?
The EBITDA calculation can be especially useful when trying to understand the valuation of a company in comparison with other companies in its industry.
Davies gives the example of two hypothetical companies and singles out depreciation as an expense to exclude. Each company earned $100 million before depreciation — but the first company’s factory is 15 years old, and its depreciation is $3 million. Meanwhile, the second company’s factory is only one year old, with depreciation of $15 million.
Without removing depreciation from the calculation, it would appear that the second company is less profitable than the first even though they still made the same amount of money.
“For the purpose of comparing two companies, these ‘ITDA’ numbers, while perfectly valid and legal, muddy the waters,” Davies says.
The measure helps investors zero in on operating cash flow.
“This method strips out expenses that are somewhat beyond the control of the company, giving a baseline valuation,” says Todd Scorzafava, partner in charge of wealth management at Eagle Rock Wealth Management.
The Cons of EBITDA
There are other elements besides EBITDA to consider when evaluating corporate health. Also keep in mind that EBITDA isn’t a metric that companies are required to use under U.S. generally accepted accounting principles (GAAP).
A con to consider for the calculation is that not only is EBITDA used as a short cut for measuring profits, but David Trainer, CEO of New Constructs in Nashville, Tennessee, says Wall Street and public companies have created multiple versions or calculations for EBITDA.
“One analyst’s version of EBITDA does not necessarily match another analyst’s, and if investors don’t look closely at the reports/models of the analysts, they could be further misled by assuming that every measure of EBITDA is the same,” Trainer says.
Some investors don’t like using EBITDA because there are limitations to the formula and it’s susceptible to manipulation. Legendary investor Warren Buffet says he stays away from EBITDA because it can be used to “dress up” financial statements, making a weak company appear to have financial strength.
EBITDA vs. Net Income
At this point, you may be asking yourself: Why not just use net income, which is simply revenue minus expenses?
Net income provides business earnings that include all the metrics EBITDA excludes. Net income shows business profitability after considering all expenses, meaning it can be seen as a more comprehensive view of a company’s profitability.
That said, “because many companies use non-cash expenses such as depreciation and amortization to lower their taxable income, net income is often not the best measure of the cash flow potential of a company,” says Sam Brownell, founder at Stratus Wealth Advisors.
Even though EBITDA can provide a useful snapshot of a company’s profitability and allow for easier comparisons to other companies in an industry, it’s best to incorporate additional metrics into your review for a more holistic understanding of a company’s value.
“Just be aware that the costs in ‘ITDA’ numbers are very real and that EBITDA is just one way of many that exist to try and compare companies within an industry from different perspectives,” Davies adds.
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Update 05/05/21: This story was published at an earlier date and has been updated with new information.