Earnings before interest, taxes, depreciation, and amortization (EBITDA) gets a bad rap in some circles of the financial world. But does this financial measure deserve the investor distaste?

EBITDA is an oft-used measure of the value of a business. But critics of this value often point out that it is a dangerous and misleading number because it is often confused with cash flow. Yet, this number can actually help investors create an apples-to-apples comparison, without leaving a bitter aftertaste.

EBITDA Calculation

EBITDA is calculated by taking net income and adding interest, taxes, depreciation and amortization expenses back to it. EBITDA is used to analyze a company's operating profitability before non-operating expenses (such as interest and "other" non-core expenses) and non-cash charges (depreciation and amortization). So, why is this simple figure continually reviled in the financial industry?

EBITDA Critics

Taking out interest, taxes, depreciation, and amortization can make completely unprofitable firms appear to be fiscally healthy. A look back at the dotcom companies of the 2000s provides countless examples of firms that had no hope and no earnings but became the darlings of the investment world. The use of EBITDA as a measure of financial health made these firms look attractive.

Likewise, EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues, while interest, taxes, depreciation, and amortization are taken out of the equation, almost any company could look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble, and investors will be in trouble.

EBITDA Versus Operating Cash Flow

Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use or provide cash (such as changes in receivables, payables, and inventories).

These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a company is losing money because it isn't making any sales.

EBITDA Advantages

Despite the critics, there are many who favor this handy equation. Several facts are lost in all the complaining about EBITDA, but they are openly promoted by the metric's cheerleaders.

The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow available to pay debt on long-term assets, such as equipment and other items with a lifespan measured in decades rather than years. Dividing EBITDA by the amount of required debt payments yields a debt coverage ratio. Factoring out the "ITDA" of EBITDA was designed to account for the cost of the long-term assets and provide a look at the profits that would be left after the cost of these tools was taken into consideration. This is the pre-1980s use of EBIDTA and is a perfectly legitimate calculation.

Another factor that is often overlooked is that for an EBITDA estimate to be reasonably accurate, the company under evaluation must have legitimate profitability. Using EBITDA to evaluate old-line industrial firms is likely to produce useful results. This idea was lost during the 1980s when leveraged buyouts were fashionable, and EBITDA began to be used as a proxy for cash flow. This evolved into the more recent practice of using EBITDA to evaluate unprofitable dotcoms as well as firms such as telecoms, where technology upgrades are a constant expense.

EBITDA can also be used to compare companies against each other and industry averages. In addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous factors and allows a more "apples-to-apples" comparison.

Ultimately, EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Remember "cash is king" because it shows "true" profitability and a company's ability to continue operations.

EBITDA Analysis Example

The experience of the W.T. Grant Company provides a good illustration of the importance of cash generation over EBITDA. Grant was a general retailer in the time before commercial malls, being a blue chip stock of its day.

Unfortunately, Grant management made several mistakes. Inventory levels increased, and the company needed to borrow heavily to keep its doors open. Because of the heavy debt load, Grant eventually went out of business and the top analysts of the day that focused only on EBITDA missed the negative cash flows.

Many of the missed calls of the end of the dotcom era mirror the recommendations Wall Street once made for Grant. In this case, the old cliché is right: history does tend to repeat itself. Investors should heed this warning.

EBITDA Pitfalls

In some cases, EBITDA can produce misleading results. Debt on long-term assets is easy to predict and plan for, while short-term debt is not. Lack of profitability isn't a good sign of business health regardless of EBITDA. In these cases, rather than using EBITDA to determine a company's health and put a valuation on the firm, it should be used to determine how long the firm can continue to service its debt without additional financing.

A good analyst understands these facts and uses the calculations accordingly in addition to his or her other proprietary and individual estimates.

Bottom Line

EBITDA doesn't exist in a vacuum. The measure's bad reputation is mostly a result of overexposure and improper use. Just as a shovel is effective for digging holes, it wouldn't be the best tool for tightening screws or inflating tires. Thus, EBITDA shouldn't be used as a one-size-fits-all, stand-alone tool for evaluating corporate profitability. This is a particularly valid point when one considers that EBITDA calculations do not conform to generally accepted accounting principles (GAAP).

Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given firm, a multitude of measures must be taken into consideration. If identifying great companies was as simple a checking a single number, everybody would be checking that number, and professional analysts would cease to exist.