EBITDA: Meaning, Formula, and History

EBITDA

Zoe Hansen / Investopedia

What Is EBITDA?

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.

EBITDA is not a metric recognized under generally accepted accounting principles (GAAP). Some public companies report EBITDA in their quarterly results along with adjusted EBITDA figures typically excluding additional costs, such as stock-based compensation.

Increased focus on EBITDA by companies and investors has prompted claims that it overstates profitability. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis.

Key Takeaways

  • Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a widely used measure of core corporate profitability.
  • EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income.
  • EBITDA lets investors assess corporate profitability net of expenses dependent on financing decisions, tax strategy, and discretionary depreciation schedules.
  • Some, including Warren Buffett, call EBITDA meaningless because it omits capital costs.
  • The U.S. Securities and Exchange Commission (SEC) requires listed companies to reconcile any EBITDA figures they report with net income and bars them from reporting EBITDA per share.
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EBITDA

EBITDA Formulas and Calculation

If a company doesn’t report EBITDA, it can be easily calculated from its financial statements.

The earnings (net income), tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut for calculating EBITDA is to start with operating profit, also called earnings before interest and taxes (EBIT), then add back depreciation and amortization.

There are two distinct EBITDA formulas, one based on net income and the other on operating income. The respective EBITDA formulas are:

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

and

EBITDA = Operating Income + Depreciation & Amortization

Understanding EBITDA

EBITDA is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices.

Like earnings, EBITDA is often used in valuation ratios, notably in combination with enterprise value as EV/EBITDA, also known as the enterprise multiple.

EBITDA is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines.

Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance.

Annual changes in tax liabilities and assets that must be reflected on the income statement may not relate to operational performance. Interest costs depend on debt levels, interest rates, and management preferences regarding debt vs. equity financing. Excluding all these items keeps the focus on the cash profits generated by the company’s business.

Of course, not everyone agrees. “References to EBITDA make us shudder,” Berkshire Hathaway Inc. (BRK.A) CEO Warren Buffett has written. According to Buffett, depreciation is a real cost that can’t be ignored and EBITDA is not “a meaningful measure of performance.”

Example of EBITDA

A company generates $100 million in revenue and incurs $40 million in cost of goods sold and another $20 million in overhead. Depreciation and amortization expenses total $10 million, yielding an operating profit of $30 million. Interest expense is $5 million, leaving earnings before taxes of $25 million. With a 20% tax rate and interest expense tax deductible, net income equals $21 million after $4 million in taxes is subtracted from pretax income. If depreciation, amortization, interest, and taxes are added back to net income, EBITDA equals $40 million.

Net Income $21,000,000
Depreciation Amortization +$10,000,000
Interest Expense +$5,000,000
Taxes +$4,000,000
EBITDA $40,000,000

History of EBITDA

EBITDA is the invention of one of the very few investors with a record rivaling Buffett’s: Liberty Media Chair John Malone. The cable industry pioneer came up with the metric in the 1970s to help sell lenders and investors on his leveraged growth strategy, which deployed debt and reinvested profits to minimize taxes.

During the 1980s, the investors and lenders involved in leveraged buyouts (LBOs) found EBITDA useful in estimating whether the targeted companies had the profitability to service the debt likely to be incurred in the acquisition. Since a buyout would likely entail a change in the capital structure and tax liabilities, it made sense to exclude the interest and tax expense from earnings. As non-cash costs, depreciation and amortization expense would not affect the company’s ability to service that debt, at least in the near term.

The LBO buyers tended to target companies with minimal or modest near-term capital spending plans, while their own need to secure financing for the acquisitions led them to focus on the EBITDA-to-interest coverage ratio, which weighs core operating profitability as represented by EBITDA against debt service costs.

EBITDA gained notoriety during the dotcom bubble, when some companies used it to exaggerate their financial performance.

The metric received more bad publicity in 2018 after WeWork Companies Inc., a provider of shared office space, filed a prospectus for its initial public offering (IPO) defining its “Community Adjusted EBITDA” as excluding general and administrative as well as sales and marketing expenses.

Drawbacks of EBITDA

Because EBITDA is a non-GAAP measure, the way it is calculated can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because the former makes them look better.

An important red flag for investors is when a company that hasn’t reported EBITDA in the past starts to feature it prominently in results. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In those cases, EBITDA may serve to distract investors from the company’s challenges.

Ignores Costs of Assets

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 profitability is a function of sales and operations alone—almost as if the company’s assets and debt financing were a gift. To quote Buffett again, “Does management think the tooth fairy pays for capital expenditures?”

What Defines Earnings?

While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from excluding interest, taxation, depreciation, and amortization costs, the earnings figure in EBITDA may still prove unreliable.

Obscures Company Valuation

All the cost exclusions in EBITDA can make a company look much less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than at bottom-line earnings, they produce lower multiples.

Consider the historical example of wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn’t mean that the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much-higher 20 times. The company traded at 48 times its estimated net income.

“There’s been some real sloppiness in accounting, and this move toward using adjusted EBITDA and adjusted earnings has produced some companies that I think are trading on valuations that are not supported by the real numbers,” hedge fund manager Daniel Loeb said in 2015.

Not much has changed on that front since then. Investors using solely EBITDA to assess a company’s value or results risk getting the wrong answer.

EBITDA vs. EBT and EBIT

Earnings before interest and taxes (EBIT), as mentioned earlier, is a company’s net income excluding income tax expense and interest expense. EBIT is used to analyze the profitability of a company’s core operations. The following formula is used to calculate EBIT: 

EBIT = Net Income + Interest Expense + Tax Expense \textit{EBIT} = \text{Net Income} + \text{Interest Expense} + \text{Tax Expense} EBIT=Net Income+Interest Expense+Tax Expense


Since net income includes interest and tax expenses, to calculate EBIT, these deductions from net income must be reversed. EBIT is often mistaken for operating income since both exclude tax and interest costs. However, EBIT may include nonoperating income while operating income does not.

Earnings before tax (EBT) reflects how much of an operating profit has been realized before accounting for taxes, while EBIT excludes both taxes and interest payments. EBT is calculated by adding tax expense to the company’s net income.

By excluding tax liabilities, investors can use EBT to evaluate performance after eliminating a variable typically not within the company’s control. In the United States, this is most useful for comparing companies that might be subject to different state rates of federal tax rules.

EBT and EBIT do include the non-cash expenses of depreciation and amortization, which EBITDA leaves out.

EBITDA vs. 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 but also includes changes in working capital, including receivables, payables, and inventory, that use or provide cash.

Working capital trends are an important consideration in determining how much cash a company is generating. If investors don’t include working capital changes in their analysis and rely solely on EBITDA, they may miss clues—for example, such as difficulties with receivables collection—that may impair cash flow.

How do you calculate earnings before interest, taxes, depreciation, and amortization (EBITDA)?

You can calculate earnings before interest, taxes, depreciation, and amortization (EBITDA) by using the information from a company’s income statement, cash flow statement, and balance sheet. The formula is as follows:

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

What is a good EBITDA?

EBITDA is a measure of a company’s profitability, so higher is generally better. From an investor’s point of view, a “good” EBITDA is one that provides additional perspective on a company’s performance without making anyone forget that the metric excludes cash outlays for interest and taxes as well as the eventual cost of replacing its tangible assets.

What is amortization in EBITDA?

As it relates to EBITDA, amortization is the gradual discounting of the book value of a company’s intangible assets. Amortization is reported on a company’s income statement. Intangible assets include intellectual property such as patents or trademarks as well as goodwill, the difference between the cost of past acquisitions and their fair market value when purchased.

The Bottom Line

EBITDA is a useful tool for comparing companies subject to disparate tax treatments and capital costs, or analyzing them in situations where these are likely to change. It also omits non-cash depreciation costs that may not accurately represent future capital spending requirements. At the same time, excluding some costs while including others has opened the door to the metric’s abuse by unscrupulous corporate managers. The best defense against such practices is to read the fine print reconciling the reported EBITDA to net income.

Article Sources
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  1. U.S. Securities and Exchange Commission. “Non-GAAP Financial Measures.”

  2. CNBC. “Why Charlie Munger’s ‘Bulls--t Earnings’ Metric Is Used by So Many Tech Companies.”

  3. Berkshire Hathaway. “2000 Annual Report,” Pages 17 and 65 (Pages 18 and 66 of PDF).

  4. Barron’s. “Liberty Media: Better Than Berkshire.”

  5. A Simple Model. “Who Invented EBITDA?

  6. William N. Thorndike Jr., via Google Books. “The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success,” Page 91.

  7. Moody’s Investors Service. “Putting EBITDA In Perspective,” Page 3.

  8. Forbes. “EBITDA Addiction Growing at Dot-Coms.”

  9. U.S. Securities and Exchange Commission. “WeWork Companies Inc. Form S-1.”

  10. The Wall Street Journal. “A Look at WeWork’s Books: Revenue Is Doubling but Losses Are Mounting.”

  11. Berkshire Hathaway. “2000 Annual Report,” Page 17 (Page 18 of PDF).

  12. Bloomberg. “Loeb Boosts Short Bets Citing Sloppy Accounting, Volatility.”