What is EBITDA?
Over time, analysts have developed a range of methodologies that they use to assess the value of companies. EBITDA is one such method. What does EBITDA stand for? It is an acronym for earnings before interest, taxes, depreciation and amortisation.
EBITDA is a measure of a company's overall financial performance and, in some circumstances, is used as an alternative to net income. Generally, it can be said that it estimates how much profit a company is generating with its current assets.
The usual shortcut to calculate EBITDA is by adding depreciation and amortisation to operating profit, also called earnings before interest and tax (EBIT).
It’s important to note that there’s no standard method for calculating EBITDA, and you may find other formulas used by companies and analysts. This is due to the fact that there’s no legal requirement for companies to disclose their EBITDA, according to the US generally accepted accounting principles (GAAP). It can be calculated using the information found in a company's financial statements – the earnings, interest and tax figures are found on the income statement, while the depreciation and amortisation figures are typically reported on the cash-flow statement or in the notes to operating profit.
As it excludes the effects of financing and capital expenditures, EBITDA is often used to analyse and compare profitability among companies and industries. It can also be compared to revenue and enterprise value and used in valuation ratios.
Where have you heard of EBITDA?
Since it was first coined by billionaire investor John Malone, EBITDA has become a commonly used method for valuing companies. If you are an investor in stock markets, you will find that there are no shortages of EBITDA examples that you may have heard of. These days, investors can simply Google the name of any major company they wish to invest in and find its EBITDA online.
What do you need to know about EBITDA?
While EBITDA calculations can be extremely useful to analysts and investors, they should be treated with caution. Despite the fact that the figure is frequently used, it’s not an official accounting practice, and so it’s not regulated by the governing bodies of that jurisdiction. Since EBITDA does not fall under GAAP as a measure of financial performance, its calculation varies from one company to another.
Further, many investors don’t regard EBITDA as a reliable method for valuing companies as the calculation assumes that the business never has to pay interest, taxes, or cover the cost of any equipment/maintenance work. As such, the true value of the company is never identified as the cost of making a profit is not entirely factored into the calculation.
Some companies may choose to emphasise EBITDA over net income as it’s more flexible and can distract investors from other problem areas in the financial statements. As such, EBITDA can sometimes be used deliberately to hide a business’s real profit performance.
Like any other measure, EBITDA should not be used alone when making investment decisions. To develop a full picture of a company’s financial health, a large number of figures should be taken into account.