If you read the business pages for any length of time, you’re likely to come across a rather clunky acronym: Ebitda. The acronym stands for earnings before interest, tax, depreciation and amortisation.
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.
What is Ebitda?
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, tax rates, or different accounting policies on, for example, the depreciation of fixed assets.
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 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.
Ebitda measures a firm’s profitability before these factors are taken into account. 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. The two businesses can be compared on a like-for-like basis by taking their enterprise value (EV – the market value of all their shares in issue, plus net borrowing or less net cash) and comparing this with Ebitda.
By comparing Ebitda to the company’s enterprise value, 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. 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 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 profits that can be paid to investors (as opposed to helping private equity buyers gauge how much debt a firm could be loaded up with).
EPS 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.
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