Understanding Core Concepts

Understanding EBITDA

EBITDA is one of the most common multiples used to measure a companies profitability. Within the realm of investment banking as well as many other verticals, EBITDA is a useful valuation tool used to assist analysts in the valuing of a company. There is a high likelihood that you will run into questions surrounding EBITDA during an interview, especially within investment banking. It is key that you understand what EBITDA shows investors and bankers, as well as how to arrive at this financial metric.

Let’s take a look…

What is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. This financial metric is an alternative to net income, which measures the profitability of a company and measures its ability to generate cash through operations. EBITDA does this by taking operating income (EBIT) - generally reported on the bottom of the income statement - and adds back depreciation and amortization which is found in the cash flow statement.

It is important to note that EBITDA is not recognized under GAAP

Calculating EBITDA

EBITDA can be calculated in two different ways as follows:

Net Income Method:

Operating Income Method:

Application of EBITDA in Valuation

EBITDA aims to measure the profitability of a company before any other underlying expenses (interest, taxes, D&A). Essentially, EBITDA looks for a companies ability to generate profits regardless of depreciation or other financing decisions.

EBITDA is often used in valuation ratios such as EV/EBITDA (enterprise multiple) in order to help investors compare the company value to true cash earnings.

EBITDA is also able to be forecasted once investors are able to forecast the three financial statement models in order to arrive at a company’s potential growth 3-5 years down the road. This is crucial for investors and bankers as knowing the future value of a company is a key metric to understanding the health and profitability. This can be useful for helping companies go public, raise capital, and provide information to structure an m&a deal.

Advantages and Disadvantages of EBITDA

Advantages:

1. Indicates how well a company is managing it’s day-to-day operations, as cost of goods sold is included in EBITDA, showing its profitability

2. Good indicator of the current health and potential of a business (does this better than net income and gross profit as they cannot accurately display the money being retained after expenses)

Disadvantages:

1. EBITDA fails to cover key facets that may severely affect a companies financials. If the company is paying high interest on its debt, then they can be in financial trouble.

2. EBITDA ignores cost of assets

3. Figures could be unreliable, as different companies may use “accounting games” and therefore distort this metric

4. Multiples of EBITDA’s stock price produce lower multiples (essentially makes the company look less expansive than it really is)

EBITDA vs EBT vs EBIT

EBIT

Used to observe a company’s profitability of core operations, through using the following formula:

It is important to note that EBIT and operating income are not the same, as EBIT includes non-operating income, while operating income does not.

EBT

Used to observe how much operating profit was realized before taxes, through using the following formula:

Eliminates externalities outside the company’s control (i.e. the U.S. gov changing tax rates).

Key Takeaways

• EBITDA is a common metric to observe corporate profitability

• Found through adding interest expense, tax expense, and D&A to net income

• EBITDA is a non-GAAP metric

• There are to ways to calculate EBITDA (operating income vs net income methods)

• The higher the multiple, the better (shows higher ability to generate profits)

• Very big flaw is that it doesn’t include the cost of assets and can obscure interest rate risk