Earnings before interest, taxes, depreciation and amortization (EBITDA) is a popular equity evaluation metric for analyzing companies in the telecommunications sector mainly because of what the metric excludes, such as depreciation.

The Nature of the Telecommunications Sector

To understand the usefulness of EBITDA as an evaluation metric, an investor must understand the nature of the telecommunications sector. The sector is, overall, characterized by being 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.

An additional factor to consider is that telecom firms sometimes receive tax incentives from the government. These tax incentives can result in rather 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

One advantage of using EBITDA for evaluations is by excluding 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 also used in other valuation measures commonly applied to telecommunications companies, including EV/EBITDA and debt/EBITDA.

EBITDA Drawbacks

One of the major strengths of EBITDA, its exclusion of capital expenditures, can 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.

(For related reading, see "EBITDA: A Clear Look.")