Earnings before interest, tax, depreciation and amortisation (Ebitda) is a way of measuring profit that can make it easier to compare the valuation of two companies.

Ebitda may be helpful when it is difficult to compare firms using other profit measures – such as earnings per share (EPS) – because they have very different levels of debt, different tax rates or different accounting policies on, for example, the depreciation of fixed assets.

Ebitda measures a firm’s profitability before these factors are taken into account. The two businesses can then be compared on a like-for-like basis by taking their enterprise values (EV – the market value of all their shares in issue, plus net borrowing or less net cash) and comparing this with Ebitda.

The lower the EV/Ebitda ratio, the cheaper the company – essentially it’s like a price/earnings (p/e) ratio, but using a different measure of earnings and taking account of debt.

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. 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 when combined with other analysis tools, but it has become an overused and abused measure of value. Its strength – that it represents profit before various costs – is also its weakness, because it doesn’t represent profit that can 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 replacing assets, depreciation, paying interest on borrowings, and paying tax – all of which reduce how much profit ends up in 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. 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.