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What is 'EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization'

EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA is a measure of a company's financial performance and is used as an alternative to earnings or net income in some circumstances. EBITDA can be misleading because it strips out the cost of capital investments like property, plants and equipment. This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings.

BREAKING DOWN 'EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization'

EBITDA is essentially net income (or earnings) with interest, taxes, depreciation and amortization added back. EBITDA can be used to analyze and compare profitability among companies and industries, as it eliminates the effects of financing and capital expenditures. EBITDA is often used in valuation ratios and can be compared to enterprise value and revenue.

In its simplest form, EBITDA is calculated as:

EBITDA = Operating Profit + Depreciation Expense + Amortization Expense

The more literal formula for EBITDA is:

EBITDA = Net Income + Interest +Taxes + Depreciation + Amortization

Interest expense, and to a lesser extent interest income, is added back to net income, which neutralizes the cost of debt as well as the effect interest payments have on taxes. Income taxes are also added back to net income, which does not always increase EBITDA if the company has a net loss. Companies tend to spotlight their EBITDA performance when they do not have very impressive (or even positive) net income. It's not always a telltale sign of malicious market trickery, but it can sometimes be used to distract investors from the lack of real profitability.

Companies use depreciation and amortization accounts to expense the cost of property, plants and equipment, or capital investments. Amortization is often used to expense the cost of software development or other intellectual property. This is one of the reasons that early-stage technology and research companies feature EBITDA when communicating to investors and analysts.

Management teams will argue that using EBITDA gives a better picture of profit growth trends when the expense accounts associated with capital are excluded. While there is nothing necessarily misleading about using EBITDA as a growth metric, it can sometimes overshadow a company's actual financial performance and risks.

Example of EBITDA

A retail company generates $100 million in revenue and incurs $40 million in production cost and $20 million in operating expenses. Depreciation and amortization expenses total $10 million, yielding an operating profit of $30 million. Interest expense is $5 million, which equals earnings before taxes of $25 million. With a 20% tax rate, net income equals $20 million after $5 million in taxes are subtracted from pre-tax income. If depreciation, amortization, interest and taxes are added back to net income, EBITDA equals $40 million.

Example of EBITDA calculation

Many investors use EBITDA to make comparisons between companies with different capital structures or tax jurisdictions. Assuming that two companies are both profitable on an EBITDA basis, a comparison like this could help investors identify a company that is growing more quickly from a product sales perspective.

For example, imagine two companies with different capital structures but a similar business. Company A has a current EBITDA of $20,000,000, and Company B has EBITDA of $17,500,000. An analyst is evaluating both firms to determine which has the most attractive value. From the information presented so far, it makes sense to assume that Company A should be trading at a higher total value than Company B. However, once the operational expenses of depreciation and amortization are added back in, along with interest expense and taxes, the relationship between the two companies is more clear.

Example of EBITDA comparison between two companies

In this example, both companies have the same net income largely because Company B has a smaller interest expense account. There are a few possible conclusions that can help the analyst dig a little deeper into the true value of these two companies.

  1. Is it possible that Company B could borrow more and increase both EBITDA and net income? If the company is underutilizing its ability to borrow, this could be a source of potential growth and value.

  2. If both companies have the same amount of debt, perhaps Company A has a lower credit rating and must pay a higher interest rate. This may indicate additional risk compared to Company B and a lower value.

  3. Based on the amount of depreciation and amortization, Company B is generating less EBITDA with more assets than Company A. This could indicate an inefficient management team and a problem for Company B's valuation.

The Drawbacks of EBITDA

EBITDA does not fall under Generally Accepted Accounting Principles (GAAP) as a measure of financial performance. Because EBITDA is a "non-GAAP" measure, its calculation can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because it is more flexible and can distract from other problem areas in the financial statements.

An important red flag for investors to watch is when a company starts to report EBITDA prominently when it has't done so in the past. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In this circumstance, EBITDA can serve as a distraction for investors and may be misleading.

EBITDA was a popular metric in the 1980s to measure a company's ability to service the debt used in a leveraged buyout (LBO). Using a limited measure of profits before a company has become fully leveraged in an LBO is appropriate. EBITDA was popularized further during the "dotcom" bubble, when companies had very expensive assets and debt loads that were obscuring what analysts and managers felt were legitimate growth numbers.

A common misconception is that EBITDA represents cash earnings. However, unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes that profitability is a function of sales and operations alone – almost as if the assets and financing the company needs to survive were a gift.

EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment. For example, a company may be able to sell a product for a profit, but what did it use to acquire the inventory needed to fill its sales channels? In the case of a software company, EBITDA does not recognize the expense of developing the current software versions or upcoming products.

EBITDA Summary

Earnings before interest, taxes, depreciation and amortization (EBITDA) adds depreciation and amortization expenses back into a company's operating profit. Analysts usually rely on EBITDA to evaluate a company's ability to generate profits from sales alone and to make comparisons across similar companies with different capital structures. EBITDA is a non-GAAP measure and can sometimes be used intentionally to obscure the real profit performance of a company. Because of these issues, EBITDA is featured more prominently by developmental-stage companies or those with heavy debt loads and expensive assets.

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