Successful investors attempt to determine the intrinsic value of companies they’re considering investing in through research and various measures.
One important measure of a company’s financial performance is known as the EBITDA.
The metric was popularized in the 1980s as a way to determine if a company could afford to service its debt after a restructuring. Today, it’s used for multiple purposes. But what exactly is it and how is it used?
What Is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is used to measure corporate profitability. A company’s EBITDA gives investors a clear view of performance while alleviating the noise of financing and capital expenditures.
The metric is a non-GAAP (generally accepted accounting principles) measure that points to how a company performs without accounting for costs that are outside of its control. Although non-GAAP metrics aren’t required for external reporting or public disclosures, they give investors a deeper look into corporate performance.
EBITDA profits occur when a company achieves positive profits before interest, taxes, depreciation, and amortization are accounted for.
How Is EBITDA Used?
EBITDA was first popularized as a metric to determine whether a company could afford the increased cost of debt following a financial restructuring. During these times, bankers would use EBITDA compared to expected interest expenses after a restructuring to make decisions about leveraged buyouts of distressed companies.
The metric was popularized before Black Monday in 1987. The metric rose to popularity once again during the dot-com bubble, with companies using it to show outsize growth with a mix of expensive assets and expensive debt.
EBITDA’s popularity is correlated with severe market downturns. When you hear companies talking of EBITDA rather than solid net earnings, it may be time to be concerned.
Investors and corporations still use EBITDA. Publicly traded companies just reaching EBITDA profits announce positive results to paint the picture that the company is profitable.
Unfortunately, the picture is often painted prettier than it should be for two reasons:
- Not Always Profitable. Solid earnings before deductions is nice, but once the cost of interest expenses, taxes, debt, and amortization are calculated in, what looks like a nice profit may actually be a loss.
- Different Starting Points. The metric is not part of GAAP for good reason. Different companies often use different starting points when determining EBITDA. For example, non-GAAP accounting techniques may be used to artificially inflate revenue, making the calculation unreliable.
When you see a penny stock or small-cap stock touting its first EBITDA profits, look into its net income to see whether the company is actually profitable, and do your own calculations to determine its true profitability before interest, taxes, depreciation, and amortization.
Despite its imperfections, the metric is still valuable to some investors who use EBITDA to determine a company’s profitability, especially when that company is a rising star.
Investors also use EBITDA to determine whether a company is undervalued or overvalued by comparing earnings before expenses to the company’s enterprise value (EV/EBITDA) or to its total revenue (TR/EBITDA). Comparing these ratios to those of other companies in the same industry helps give investors an idea of whether they’re getting a discount when they buy the stock.
However, since EBITDA is not a GAAP measure, it’s strongly recommended that investors use other valuation metrics in combination with EBITDA ratios when determining whether buying a stock represents a discount.
How to Calculate EBITDA
Calculating EBITDA is a relatively simple process that involves adding expenses back into the operating income or net income of a company. Here’s how it’s done:
The calculation can be done in one of two ways:
The Full EBITDA Formula
The long-form formula for calculating EBITDA requires adding interest, taxes, and depreciation and amortization back to the company’s reported net income.
EBITDA = Net Income + Interest Expenses + Taxes + Depreciation & Amortization
More on what each of these components mean below.
The Easy Formula
The formula below is an easier option for calculating EBITDA because you only need to add two easy-to-find numbers together.
EBITDA = Operating Income + Depreciation & Amortization
This formula works because operating income is determined by adding interest costs and taxes back to the company’s net income. Most companies break out their operating income and depreciation & amortization as line items on their earnings reports.
Net income — also referred to as profitability — is the amount of money a company makes in a predetermined period of time, usually a fiscal quarter or fiscal year, after all expenses are deducted.
Like consumers, corporations use debt. Companies may use debt to finance operations, fund research & development, or for the acquisition of competitors. But the bottom line is that most publicly traded companies have debts.
With debt comes interest. The interest in this equation is the amount of interest the company pays on its debt over the course of the fiscal quarter or fiscal year, depending on which time frame you’re assessing.
Corporations must pay taxes in order to do business in the United States, just like individuals pay income taxes. EBITDA looks only at earnings before taxes, so these costs are added back to the company’s net income.
Depreciation & Amortization
Depreciation & amortization relates to non-cash expenses on intangible assets, such as patents, trademarks, copyrights, and other assets that lead to exclusivity periods. This line item reflects the loss of value of intangible assets like these over time.
For example, say a pharmaceutical company has an exclusivity period during which its competitors aren’t allowed to manufacture generic versions of its new drug. A 10-year exclusivity period is far more valuable than a 1-year exclusivity period. As an exclusivity period approaches its expiration, its monetary value to the company shrinks.
Example EBITDA Calculation
Say a company’s operating income is reported as $20 million during a quarter. Depreciation and amortization costs to the company are $5 million during the quarter. The company’s EBITDA would be $25 million: the $20 million operating income plus $5 million in depreciation and amortization expenses.
Say the same company had a net income of $10 million during the quarter. It paid $8 million in interest costs on its debt and $2 million in taxes. The result of the long-form equation would be the same $25 million, with a formula that looks like this:
$25 million = $10 million (Net Income) + $8 Million (Interest Costs) + $2 million (Taxes) + $5 million (Depreciation & Amortization)
Pros and Cons of Using EBITDA
As with any financial tool, there are some pros and cons that should be considered before using EBITDA to evaluate an investment.
Pros of EBITDA to Evaluate an Investment
EBITDA is a popular metric for multiple reasons. Some of the biggest benefits to using it include:
- Performance Analysis. Investors are able to see how well a company is performing in terms of total revenue compared to the bare cost of goods sold, giving the investor a clear view of performance without tax, depreciation, and amortization costs that it can’t control.
- Measures Valuation. Investors often use EBITDA as a tool to determine whether a stock is trading at fair market value.
Cons of EBITDA to Evaluate an Investment
While there are plenty of reasons to use the EBITDA in your analysis of a company, there are also reasons to stay away. Some drawbacks include:
- Easily Manipulated. Companies that report this metric can easily manipulate it to look better than it should. For example, a company may use non-GAAP accounting to artificially inflate earnings prior to the deduction of tax, depreciation, and amortization, resulting in an inflated view of profitability.
- Doesn’t Show Operating Expenses. It’s important that investors understand the expenses companies pay to keep their business running. Two companies may have the same EBITDA, but one could be well into profits and the other could be funding their operations entirely through new debt. EBITDA doesn’t include the everyday operating expenses a company incurs, so it shouldn’t be the only metric used to evaluate a business.
Other Metrics to Consider Besides EBITDA
There are several metrics investors should look into before making an investment decision. Instead of relying solely on EBITDA, here are some other key measurements of a company’s business to research before investing:
- Net Income. Net income is the profit a company makes after all expenses are accounted for.
- Revenue. The amount of money a company earns on the top line is important. Revenue growth is generally related to corporate strength.
- Operating Income. Operating income is similar to EBITDA except it does not add the value of depreciation and amortization back into a company’s earnings.
EBITDA Frequently Asked Questions
Wisdom is built through asking questions, and there are plenty of frequently asked questions about EBITDA. Some of the most common include:
What Is a Good EBITDA?
A good EBITDA is one that’s higher than that of competitors of the same size and industry. This will vary significantly depending on various factors, so it’s best to compare multiple companies to determine what a strong reading is in that particular subsector of the market.
What Is an EBITDA Margin?
The EBITDA margin is a measure of a company’s EBITDA as a percentage of its total revenue. This reflects a company’s core earnings before costs that are outside of its control.
What’s the Difference Between EBITDA vs. EBIT?
EBIT, or earnings before interest and taxes, is also called operating profit. The measure is used to determine the profitability of a company without the inclusion of capital structure and tax expenses.
What Is the EV to EBITDA Multiple?
The EV to EBITDA multiple tells you how valuable a company is in relation to its EBITDA. For example, if the enterprise value of a company is $10 million and its EBITDA is $5 million, its EV to EBITDA multiple is two.
EBITDA is a valuable metric investors use when researching and analyzing publicly traded companies. However, it has limitations, including the lack of inclusion of varying costs and a company’s ability to manipulate its results.
As such, although this is a valuable metric to consider during your due diligence, it should be coupled with other metrics to get a more complete financial picture.