If you read the business pages for any length of time, you’re likely to come across a rather clunky acronym: Ebitda. What does it mean, and why does anyone use it?
Ebitda is a way of measuring profit that can make it easier to compare the valuation of two companies. The acronym stands for earnings before interest, tax, depreciation and amortisation.
So it’s the amount of money a company makes before it has to pay the following costs:
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- interest on any debt outstanding;
- tax on its profits;
- depreciation – that is, accounting for changes in the value of tangible goods such as equipment and premises over time;
- and amortisation – accounting for changes in the value of intangible goods such as brands or intellectual property over time.
Why would you use Ebitda?
One of the main reasons analysts use Ebitda to get a better view of corporate performance is because it focuses on the profitability of a business based on the company’s day-to-day operations, without any distortions caused by how the company is funded (eg its debt levels), its tax efficiency, or its accounting policies. Ebitda measures a firm's profitability before all of these factors are taken into account.
As a result of this, you can use Ebitda in valuation ratios to compare two companies which are in the same line of business, but are funded with different amounts of borrowing, for example. In this case, Ebitda can be more useful than other profit measures, such as earnings per share (EPS), for getting an insight into how the two businesses compare.
How do you use Ebitda in valuation ratios?
You can compare Ebitda to a company’s enterprise value. To get enterprise value (EV), you take the total value of the company’s shares (that is, its market capitalisation); add any outstanding debts; and subtract any cash.
You then simply divide enterprise value by Ebitda – this is the EV/Ebitda ratio. The higher the number, the more expensive it is.
As you may have noticed, EV/Ebitda is similar to the price/earnings (p/e) ratio. The main difference is that it takes a broader view of how the company is financed by taking debt as well as equity into account, which the p/e does not. In turn, this makes comparing two companies in the same sector more straightforward.
The strengths and weaknesses of Ebitda
Ebitda first came into common use in the US in the 1980s during the boom in leveraged buyouts (LBOs), as a measure of the ability of a company to service a higher level of debt. This had a major impact on what a prospective buyer would be willing to pay – the more debt a company could handle, the more they could borrow to fund the purchase. Over time it became popular in industries with expensive assets that had to be written down over longer periods of time. Today it is commonly quoted by many companies.
Ebitda can be useful, but it can also be abused to show an investment in a more favourable light than is warranted. Its strength – that it represents profit before various costs – is also its weakness, because it doesn’t represent profit that can actually be paid to investors (as opposed to helping private-equity buyers to gauge how much debt a firm could be loaded up with).
Earnings per share isn't perfect, but at least it allows for the cost of replacing assets, depreciation, paying interest on borrowings, and paying tax all of which reduce how much profit ends up in an ultimate investors' hands.
Another criticism of Ebitda is that in a capital-intensive industry it is misleading to take out fixed (long-term) asset costs altogether. In such industries, EBITA might be used. This is just 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.
So as with any other valuation measure, Ebitda is one you should definitely have in your analysis toolbox, but it should be used in conjunction with other measures rather than on its own.
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