What makes a stock overvalued or undervalued? Financial metrics like earnings before interest, taxes, depreciation and amortization, or EBITDA, help investors determine a company’s valuation and investment potential.
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Valuation metrics and ratios allow investors to compare different stocks. EBITDA can help investors differentiate between a stock that’s a fresh prospect and a rotten apple, and discover optimal investment opportunities. Here’s what you need to know about this financial tool:
— What is EBITDA?
— EBITDA formula.
— EBITDA vs. net income.
— How investors use EV/EBITDA ratios.
— Other applications of EBITDA.
— Limitations of EBITDA.
What Is EBITDA?
With many financial metrics available, how do investors use earnings before interest, taxes, depreciation and amortization in the first place? For starters, EBITDA provides investors with an idea of a company’s cash flows before certain expenses and indicates whether a company is headed in the right direction. It also offers a way to compare two companies within the same industry.
Certified financial planner Ron Pac, partner at Trivium Point Advisory in White Plains, New York, explains how investors can use EBITDA when analyzing stocks: “This figure can offer you a snapshot of a business’s performance by focusing on earnings from operations without the influence of external factors like tax rates or loan interest. These two factors tend to come into play when companies are acquiring other companies, financing machinery to run the business, etc.”
Many corporations borrow money to finance their operations and new projects. These companies must pay interest on their loans. EBITDA does not include this expense, since companies have varying debt structures.
“Think of EBITDA as the starting line in a race, whereas net income is the finish line, accounting for all hurdles in between.” – Ron Pac, partner at Trivium Point Advisory
Taxes also get removed from EBITDA because they do not reflect a company’s financial performance. Tax payments boil down to several outside factors, including geographical location. For instance, the U.S. has a 21% corporate tax rate due to the Tax Cuts and Jobs Act of 2017. However, German corporations only have a 15.825% tax rate. If a German corporation and a U.S. corporation generate the same earnings, the U.S. corporation will have lower profits due to the higher tax rate. Looking at net income makes the German corporation appear more enticing, but EBITDA removes the tax advantage the German corporation enjoys over its U.S. counterpart.
Depreciation and amortization are accounting expenses that do not always reflect a company’s actual losses. Corporations use these expenses to increase their tax deductions and end up with lower tax bills. High write-offs can reduce profits and may even indicate a net loss despite robust cash flow.
EBITDA Formula
Investors can calculate EBITDA with one of these formulas:
Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA
Operating Profit + Depreciation + Amortization = EBITDA
EBITDA vs. Net Income
A company’s EBITDA is different from its bottom line. Investors looking for a company’s profits can look for net income. This metric covers earnings but includes the expenses EBITDA omits.
Whitney Solcher, partner, senior advisor and chief investment officer at Ulrich Investment Consultants, provides additional insights on the differences between these two metrics: “EBITDA is commonly used as a metric to value a company’s worth as an operating business. This differs from net income, which incorporates interest, taxes, amortization and depreciation, and therefore tends to be a lower number.”
Some expenses included in net income affect a company’s cash flow and financial stability. Interest payments are real expenses that minimize profit margins, for example. And although a U.S. corporation may have a different tax rate than a foreign corporation, it’s still an important detail that influences how much money a corporation retains at the end of the year.
However, depreciation and amortization don’t affect cash flow, hurt a business or restrict its access to capital. Investors should consider these factors when deciding whether to compare companies based on their EBITDA or net income.
“Think of EBITDA as the starting line in a race, whereas net income is the finish line, accounting for all hurdles in between,” Pac suggests.
Some hurdles carry more meaning than others, and investors have different opinions. Some investors can overlook depreciation and amortization expenses because they do not determine cash flow. Other investors want to consider these expenses because properties need repairs and intellectual property can lose value.
How Investors Use EV/EBITDA Ratios
EBITDA helps investors differentiate between undervalued and overvalued stocks. Many investors use the EV/EBITDA multiple to compare corporations.
Enterprise value, or EV, reflects a company’s market cap, debt and cash. For this calculation, debt increases a company’s value, while cash decreases its enterprise value. Corporations with low EV/EBITDA ratios tend to be more attractive. For instance, a company with an EV/EBITDA ratio of 10 often has a more reasonable valuation than a company with an EV/EBITDA ratio of 11.
What’s considered a good EV/EBITDA ratio depends on the industry. “EBITDA is commonly assigned a multiple to value a company, as it is a clear picture of the cash flow generation of the business,” Solcher explains. “Multiples can vary across industries, as (some) sectors tend to maintain higher debt ratios, while other industries may have more hard assets — such as energy companies versus technology companies that tend to have less.”
High-flying tech companies tend to have higher EV/EBITDA ratios than blue-chip automakers because the tech companies may have more potential for growth. Investors can compare EV/EBITDA ratios among tech companies to assess which ones have the most reasonable valuations.
Using a blue-chip company to assess a growth stock’s valuation is like comparing a race car to an SUV. It’s an unreasonable comparison, and it illustrates why investors should compare companies within the same sector. Comparing them against broader indexes like the S&P 500 and Nasdaq 100 can also lead to better investments.
Other Applications of EBITDA
EBITDA isn’t only useful for stock investors. Investors can use EBITDA to assess private businesses they want to acquire. Business owners can also use their EBITDA figures to pitch a valuation to potential buyers.
EBITDA’s applications also extend to lenders who want to gauge whether a business can repay its loans. Since EBITDA reflects a company’s operating cash flow, it can offer a better picture for the lender’s risk assessment.
Limitations of EBITDA
Although EBITDA is a popular metric that gives investors more information about a company’s financials, it isn’t perfect. Understanding the limitations of EBITDA can help you view corporations from a better perspective and decide if you want to incorporate EBITDA into your analysis.
A main weakness with EBITDA is how much it removes from a company’s expenses. A corporation with a higher tax rate still has to pay at that higher rate, for example. Taxes still represent money leaving a company’s coffers, and EBITDA ignores that consideration.
“Though it offers a glimpse into operational performance, it lacks the scope to provide a full picture, omitting essential factors like debt and cash flow,” Pac explains. “Thus, while EBITDA can guide you in making informed decisions, it shouldn’t be the only metric you consider.”
EBITDA has its fair share of supporters and critics. Many investors look at iconic investors like Warren Buffett for guidance. Buffett is a critic of EBITDA who points out that a business can be both EBITDA positive and cash flow negative.
Companies can’t stay in business if they generate negative cash flow. Omitting key expenses like interest, taxes, depreciation and amortization can paint a more generous picture of a corporation’s financial performance and longevity.
Some investors use EBIT instead, which is a company’s net income before taxes and interest expenses. EBIT does take depreciation and amortization into account.
Bottom-line net income offers the full picture of how much money a company takes home after accounting for all expenses.
All of these financial metrics can give investors more information about a company. However, you should not rely on a single measurement when making investing decisions. Using multiple metrics and reviewing a company’s financials can lead to better investments.
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What Is EBITDA in Finance? Meaning and Formula originally appeared on usnews.com
Update 09/18/23: This story was published at an earlier date and has been updated with new information.
