Analysts and investors always want a reliable measure of profits that’s not unduly subjective and is close to a firm’s cash flows. Earnings before interest, tax, depreciation and amortisation (EBITDA) tries to achieve this by taking operating profit and adding back two subjective costs: depreciation and amortisation. These are fairly arbitrary charges made to reflect the wearing out of fixed assets over their ‘useful economic lives’.
This life is determined by the directors, based on how long they think an asset will generate income. But critics of EBITDA say that in a capital-intensive industry it is misleading to take out fixed (long-term) asset costs altogether.
Enter EBITA – operating profit (earnings before interest and tax) with amortisation (of intangible assets, such as goodwill and patents) added back. Depreciation is left in as an estimate of the annual cost of replacing a firm’s fixed assets.
• See Tim Bennett’s video tutorial: Beginner’s guide to investing: the EV/EBITDA ratio.