Understanding EBITDA

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Many press reports, company news releases and analyst recommendations frequently quote the acronym EBITDA. But what exactly does it mean and how valid is its use, particularly versus more traditional measures such as earnings per share and cash-flow?

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. It is 'operating income' or 'operating profit' after adding back the charges for depreciation of fixed assets and amortisation of goodwill. The reason for disregarding these charges is that they do not involve an actual cash expense.

It's pretty easy even for a non-accountant to extract the necessary information to calculate it from the company's accounts.

Most profit and loss accounts follow a similar pattern, with sales at the top. The cost of materials and other external inputs is subtracted from this figure to arrive at gross profit. From gross profit various operating expenses are deducted to arrive at operating profit. But there are some charges like depreciation of fixed assets and amortisation (annual write-offs) of goodwill that are book entries rather than actual payments.

EBITDA is, in effect, operating profit after adding back the specific non-cash items of depreciation and amortisation. There is a temptation to view EBITDA as a proxy for cash flow. But this is a dangerous assumption to make. The crucial difference between the two is that cash flow takes into account movements in working capital (stock, debtors and creditors) whereas EBITDA does not. Sharp adverse swings in working capital can reduce cash flow and are a sign of poor financial control or corporate ill-health, but EBITDA would not detect these warning signs.

The reason that the companies that make a big deal about their EBITDA do so is that it is usually a much larger number than their pre-tax profit or earnings number might be. A highly geared company can be loss-making at the pre-tax level but have positive EBITDA, because interest charges are ignored.

The use of EBITDA is generally justified on the grounds, which have previously been advanced in finance theory and taught in every business school on the planet, that capital structure (that's to say the level of a company's borrowing relative to its net assets) is irrelevant to company valuation. The events of the past year or so, with the drying up in liquidity in commercial debt markets and the collapse of many highly geared companies, should be sufficient to disprove this.

EBITDA is generally used in the context of company valuation as a ratio to enterprise value. Enterprise value (EV) is a company's net debt plus its equity market capitalisation. EV/EBITDA is a way of valuing a company irrespective of its capital structure. That's because if we add back interest charges in the denominator of the fraction, we need to add back the value of the debt associated with it in the numerator. EBITDA also has the advantage that using a figure taken before deducting tax means that international differences in company tax rates can be ignored when comparing companies.

Many big investors have used EV/EBITDA in the past as an initial screen when looking for companies to research further. Generally they have looked for a ratio of less than ten times to indicate that a company may be a potential candidate to buy. History does not relate whether institutions like this are still taking such a relaxed view of valuation.

Peter says

EV/EBITDA is a valid way of comparing companies with high levels of debt or lots of cash, or those that are making losses at the net income level but not necessarily further up the profit and loss column. You can also use it for comparing companies in the same industry but in different countries. But whether it can be used to determine the cheapness or otherwise of share in absolute terms is another matter.

Is adding back charges like depreciation and amortisation valid?

The case is easier to make for amortisation. It is usually related to amortising goodwill, an arbitrary policy now firmly part of accounting standards. But those seeking to exclude depreciation from the equation are on shakier ground. Depreciation reflects the fact that physical assets wear out and have to be replaced.

So although a notional charge at the time it is made, in contrast to amortisation of goodwill, depreciation is a marker for a real cost that must be borne by the business. It reflects the fact that there will be a cash expense in the future, which will occur when the assets are replaced.

My own view is simple: use cash flow as the yardstick for valuation rather than EBITDA in every case.