What is EBITDA?
When it comes to fundamental analysis of a company, there is one crucial metric that just can’t be ignored and it’s called EBITDA. It’s wildly used by investors, portfolio managers, and market analysts.
Today we’ll try to explain what does this metric mean and we’ll also provide a few examples.
So, What is EBITDA?
EBITDA is an acronym which stands for:
- E Earnings
- B Before
- I Interest
- T Taxes
- D Depreciation
- A Amortization
It’s a convenient metric if you need to analyze financial performance of a certain company so its use cases are similar to quick ratio, current ratio and return on assets.
How to Calculate EBITDA?
EBITDA might seem hard to calculate but it’s actually very easy to calculate.
Here is the formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
You can find all of these parameters in an income statement and the balance sheet of a company that you are researching. There is one more formula that shows us another way to calculate EBITDA:
EBITDA = Operating Income + Depreciation + Amortization
Where, operating Income, an accounting figure, can be found with the following formula:
Operating Income = Gross Income − Operating Expenses
Operating expenses include the following:
- Cost of goods sold (COGS)
- Selling, general, and administrative expense (SG&A)
It’s important to understand that there are many companies that don’t publish EBITDA.
EBT and EBIT
EBT and EBIT are very similar to EBITDA, they are ‘short versions’ of it.
Their meaning is easy to unpack because we already know what EBITDA stands for.
EBT means “Earnings Before Taxes” and EBIT means “Earnings Before Interest and Taxes”.
Why is EBITDA Important?
EBITDA suggests that we are interested in earnings before taking into account certain things such as taxes, interest, depreciation, and amortization. With EBITDA, we ignore some values to get a better picture of a company’s performance.
Why wouldn’t a market analyst want to look at an interest paid and other variables, aren’t they important? Well, for some cases - yes, but for certain kinds of businesses and situations, they are believed to be less valuable. EBITDA clearly shows the ability of a business to generate money and it does so by removing the things that are not critically important. To put it simply, EBIDTA doesn’t care how you finance a business, whether it’s your own cash (equity) or just a ton of debts. There might be a company with a dangerously looking level of debt, but as long as it can generate a positive net income, its debt or depreciation might not be a big problem.
How to Use EBITDA in Analysis?
Let’s assume that there are two small stores on the same street.
For the sake of this particular case, let’s say that they make the exact same net income, revenue, and they have the same cost of goods sold, equipment depreciation and amortization. The only difference is the way those stores were founded.
- 1st store was founded by using its owner’s equity (cash).
- 2nd store was founded with borrowed capital, therefore it has to pay interest.
Here are some numbers for our 1st store:
- Revenue: $5000
- Cost of goods sold (COGS): $2500
- Interest expense: $0
- Depreciation and amortization: $500
- Income before taxes: $2000 (5000 - 2500 - 500)
- Net income (25% tax rate): $1500 (2000 * 0.75)
- EBITDA: $2500
And for the 2nd store:
- Revenue: $5000
- Cost Of Goods Sold (COGS): $2500
- Interest Expense: $500
- Depreciation and amortization: $500
- Income before taxes: $1500 (5000 - 2500 - 500 - 500)
- Net income (25% tax rate): $1125
- EBITDA: $2500
This example, borrowed from www.fool.com, but with the different numbers, clearly demonstrates that even though the net income is obviously different, those stores still have the same EBITDA and the reason is: EBITDA only cares about revenue and COGS.
From an owner’s perspective, the 2nd store makes less money due to the fact that the owner spends cash on interest expenses, but if an outside investor decides to compare these entities, the ability to generate cash flow would be the key in both of those cases and those stores are equal in that regard.
When we compare similar companies that operate in the same industry, EBITDA can be very useful, mostly because things like interest expenses can be ‘fixed’ by paying off the debt, but the revenue or COGS are much harder to change, so they are more important for such an analysis.
LBO and EBITDA
To understand EBITDA better, we can recall the way it was created. Leveraged buyouts (LBOs) were quite popular in America in the 80-s and those sharks who were heavily involved in LBOs needed an instrument to see how well a corporation can make money after it changes its owner.
The logic behind LBOs was simple: you buy a company which can generate a stable and positive cash flow, you get rid of all of the unnecessary expenses (like R&D department, etc.) and then you borrow more money from banks by using this new profitable company as a leverage. Then you repeat this procedure and your wealth would grow as a result but you would accumulate massive debts on those companies’ balance sheets but, as long as those debts are not critical, you can borrow even more. For these purposes, the investors developed EBITDA to interest coverage ratio which simply shows if a company is capable of paying its debts.
During the so-called ‘dot com bubble’, the EBITDA indicator was popularized again in order to justify the narrative that some fast-growing companies with a massive debt loads are actually pretty stable. According to EBITDA promoters, things like interest expenses and equipment depreciation are far less important than the net income.
Disadvantages of Using EBITDA
EBITDA is a helpful and somewhat trusted metric, that is used by many analysts and managers, but there are certain disadvantages of using it as well.
First of all, EBITDA is not an official measure of financial performance of a company according to the GAAP (generally accepted accounting principles), a major American association of accountants. A large US corporation may mention its current and historical EBITDA in a letter addressed to investors or in its annual report, but usually it isn’t emphasized.
If a company suddenly starts to report and highlight its EBITDA, it’s usually a concerning sign. Such a behavior may suggest that this company had borrowed a lot of money or that it has some other shady expenses to hide.
EBITDA has even more limitations for IT companies because it doesn’t take into account any costs of development of the current version of the product.
Also, EBITDA ignores the cost of assets and although it works with the COGS expenses in one version of its formula, the fact that it ignores the way a company is financed is often criticized. The interest expenses do matter for many companies on the market.
EBITDA can also be impossible to calculate for certain companies as they use different earnings figures. To summarize, EBITDA can be misleading for stock price analysis, although it still considered to be an important metric and many students across the world are taught about it.
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