In the telecommunications sector, earnings before interest, taxes, depreciation and amortization (EBITDA) is a popular equity evaluation metric for analyzing companies mainly because of what the metric excludesdepreciation.

Because telecoms businesses invest heavily in network equipment, the EBITDA metric allows for a more accurate comparison across telecoms firms.

Key Takeaways

  • Telecoms companies invest heavily in network equipmenta capital expenditure which gets depreciated.
  • EBITDA excludes depreciation, which allows for a more accurate comparison across telecoms firms.
  • However, some analysts argue that capital expenditures should be carefully scrutinized precisely because they are so important to telecom companies.

Understanding the Telecommunications Sector

The telecommunications sector is characterized as high-growth and capital intensive, with high fixed costs and relatively high levels of debt financing. Many companies have a large base of fixed assets, leading to correspondingly high levels of depreciation expenses. To maintain a high level of service, telecoms companies must continually invest in network equipment such as switches, telecoms towers, and fiber-optic cables.

An additional factor to consider is that telecom firms sometimes receive tax incentives from the government. These tax incentives can result in volatile swings in free cash flow, which means cash flow metrics may not be the best-suited evaluation points for telecom firms. By excluding capital expenditures, depreciation and financing costs, EBITDA provides a cleaner evaluation of a company's earnings.

Advantages of the EBITDA Metric

Because EBITDA excludes the impact of accounting and financing decisions related to capital expenditures, it allows for more accurate comparisons between similar firms, especially if one firm is in the midst of extensive capital projects while the other is not.

EBITDA is considered a more reliable indicator of a company's operational efficiency and financial soundness, because it enables investors to focus on a company's baseline profitability without capital expenses factored into the assessment.

Also, from a purely practical standpoint, using EBITDA is helpful because it is used in other valuation measures commonly applied to telecom companies, including EV/EBITDA and debt/EBITDA.

EBITDA Drawbacks

One of the major strengths of EBITDAits exclusion of capital expenditurescan also be viewed as a weakness. Some analysts argue because capital expenditures are very important to telecom companies, they should be included and, in fact, carefully scrutinized.

EBITDA provides an assessment of profitability, but not of operating cash flow, a metric that provides very good tracking of a company's working capital management.