While there are A variety of measurements used for evaluating a company, there is one in particular that targets a business' value – it’s called EBITDA, an acronym that stands for "earnings before interest, taxes, depreciation and amortization."
Even though it's a seemingly straightforward metric with simple characteristics, it's best to advance investor understanding as to why some finance professionals use the tool while others opt for different measurements.
Let's look at a breakdown of what EBITDA means and why this measurement is important to understand as a valuation metric for investors for their future financial planning:
- What is EBITDA?
- What is the EBITDA formula?
- Who uses EBITDA?
- EBITDA versus net income.
- Pros and cons of EBITDA.
What is EBITDA?
EBITDA is an investment term used to measure a company's operating and financial performance and profitability by reviewing a company's income statements.
A company makes earnings but also has expenses. Those expenses include taxes, interests, depreciation and amortization.
Earnings are net income or income after taxes, basically whatever is left of a company's revenues after all expenses are taken out. 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 is more effective to eliminate them from the calculation to better determine a company's value.
Earnings before interests and taxes is called EBIT, which excludes non-operating expenses and non-cash expenses – in other words, a company's net income before interest and taxes to best focus on the business' core operations. EBIT is often used as an alternative for a company's free cash flow. By calculating EBIT, an investor can have a view into the core business operations.
The EBIT formula is:
EBIT = Net Income + Interest + Taxes
When depreciation and amortization are excluded, this is known as EBITDA. By taking out debt financing, you can better understand income generation from a company's operations. The EBITDA calculation can be used to understand the valuation of a company when comparing it with other companies within the same industry.
Investors should become familiar with financial statements so they can navigate these individual measurements and bring meaning out of them.
"Companies and industries are different and you can't rely on numbers like EBITDA or net profit without a thorough understanding of a company's financial statements," says Roger Hewins, president at Team Hewins in San Francisco.
Here is a list of financial statements needed for review when calculating a company's EBITDA:
- Balance sheet: What is owned and what a company owns in a given period.
- Income statement: This lists the profit generated.
- Cash flow statement: Where cash is spent and how much cash is generated.
EBITDA formula and how it's calculated
Experts say EBITDA is a way to standardize different capital structures to make firms comparable.
There are two ways of calculating EBITDA using the following formulas:
- Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA
- Operating Profit + Depreciation + Amortization = EBITDA
These individual factors used for the EBITDA formulas can be found on the company's balance sheet.
Depending on the company, EBITDA may have been calculated for you. If not, you need to make sure all the numbers representing EBITDA are present in the income statement; otherwise, the calculation will be difficult to determine.
In this example, Company ABC's EBITDA of $430,000 comes out to be the same using both formulas.
To get the measure of a company's revenue as a percentage, you would divide a company's EBITDA by its revenue to get what's called the EBITDA margin, earnings divided by revenue.
The EBITDA margin for Company ABC is 430,000 / 500,000 = 0.86, or 86%. A good EBITDA margin is one that is high in general but also higher than its peers. In the hypothetical example of Company ABC's case, the EBITDA margin is pretty high – meaning the company's overall financial performance is stable.
Who uses EBITDA?
This calculation is used by finance professionals to understand how profitable a company is. Investors can easily learn this calculation to help them with the valuation of a company of interest before adding it to their portfolio.
Investors who want a stake in a company need to know how much the company is making.
The EBITDA calculation provides investors with an idea of a company's cash flows before its expenses and gives investors an idea if the company is headed in the right direction, from a financial standpoint.
A company's management team uses 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 the company and to forecast a company’s future profits.
A high EBITDA margin tells the investor that the business has a strong cash flow and the company is likely to be profitable. From the perspective of a bank or debtholder, the higher the EBITDA, the better likelihood the company has of paying back creditholders.
Conversely, a low EBITDA suggests a company can be suffering from profitability issues and may present concerns with the business' financial health.
EBITDA vs. net income
It's reasonable to ask: "Why not bypass the EBITDA calculation and just look at net income?" As described above, there are certain metrics EBITDA includes and excludes to understand the operating income potential of a company's profit.
"EBITDA is an analyst's answer, the widely accepted but flawed measure of corporate earnings called net income," says Robert Johnson, finance professor at Creighton University in Omaha, Nebraska.
"EBITDA involves a series of adjustments to net income to get a measure of profitability that is not distorted by accounting or financial maneuvers," Johnson explains.
For the net income calculation, the business costs of interest, taxes, depreciation and amortization are all considered when reviewing a company's income. The calculation for net income is as follows:
Revenue – Business Costs = Net income
Net income provides business earnings that include all the metrics EBITDA excludes. Meaning, net income shows business profitability after considering all expenses to come to the earnings per share of a company.
Since net income calculates the total earnings of a business after taxes, depreciation and amortization are paid, it can be seen as a more comprehensive view of a company's profitability.
EBITDA is a suitable measurement to use for a startup company, for instance, to understand its business performance ability. Whereas, net income, considered a more durable account measurement, provides the financial well-being of a company.
Pros and cons of EBITDA
Using EBITDA is a quick way to compare companies to each other and industry averages. However, EBITDA is not a stand-alone metric that provides the full picture of a company's profitability; there are other elements to consider when evaluating corporate health.
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 don't like using EBITDA because there are limitations to the formula and it's susceptible to manipulation. 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.
Companies are not legally required to disclose EBITDA, according to U.S. GAAP (generally accepted accounting principles). This means it is not a standard accounting metric, which can reduce the calculation's credibility.
Even though EBITDA seems like a good way to capture a preliminary value of a company's core business and to compare different companies to each other, by stripping away expenses, it's probably best to incorporate additional metrics into your review for a more holistic understanding of a company's value.
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