Too embarrassed to ask: what is EBITDA?

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 one way to measure a company’s profits. 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:

• 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 is Ebitda an important measure?

One of the main reasons analysts use Ebitda is because it focuses on the profitability of a business based on its day-to-day operations, without any distortions caused by how the company is funded, its tax efficiency, or its accounting policies.

So you could use Ebitda in valuation ratios to compare two companies which are in the same line of business, but are funded with different levels of debt, for example.

By comparing Ebitda to the company’s enterprise value (which is the total value of its shares plus any outstanding debts, less cash), you can get an idea of how highly valued it is by investors.

Simply divide enterprise value by Ebitda. The higher the number, the more expensive it is.

In other words, it’s a bit like a price/earnings ratio, but one that enables the comparison of core businesses more easily.

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.

So as with any other valuation tool, it should be combined with other measures.

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