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EBITDA: Definition, components, formula and calculating EV/EBITA multiples
EBITDA is a common accounting term, but it’s very important to keep in mind that it can be used to mislead investors and has come under heavy criticism. Use accordingly.
QUOTE
“Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.”
Big ideas
- EBITDA is used to assess company profitability irrespective of accounting and financial decisions.
- EBITDA is an indicator of the operational performance of a company.
- EBITDA is not recognized under GAAP and can be a means to overstate profitability.
History of EBITDA
EBITDA was first invented by a business person with a record close to Warren Buffets’ (who is skeptical of the EBITDA measure) - John Malone. It was used in the 80s by leveraged buyout investors to determine if the company could survive the debt involved in the acquisition.
Definition
EBITDA is an acronym that stands for “Earnings Before Interest, Taxes, Depreciation, & Amortization”.
It can enable you to understand the overall profitability of a given company, and you can compare the EBITDA rating between different firms. Essentially, EBITDA outlines a company’s capability to generate profits outside of accounting and finance.
It can enable you to understand the overall profitability of a given company, and you can compare the EBITDA rating between different firms. Essentially, EBITDA outlines a company’s capability to generate profits outside of accounting and finance.
While it is useful in context, the term got a bad reputation in the dot-com bust after it was used to exaggerate profitability. In 2018, WeWork also used it in its IPO to exaggerate its profitability, excluding sales and marketing expenses. As it’s a non-GAAP measure, the way it is calculated can vary from company to company.
EBITDA is used widely in industries with high depreciation costs and asset-intensive industries with plenty of plants, machinery, and property. Where it is really useful is in terms of comparing companies in the same sector.
Plus, It can be helpful to look at the operational performance of a company outside of financial and accounting decisions (certain investment firms might specialize in reducing these), once the core operations are sound.
EBITDA is used widely in industries with high depreciation costs and asset-intensive industries with plenty of plants, machinery, and property. Where it is really useful is in terms of comparing companies in the same sector.
Plus, It can be helpful to look at the operational performance of a company outside of financial and accounting decisions (certain investment firms might specialize in reducing these), once the core operations are sound.
How to calculate EBITDA?
Companies are not required to report EBITDA. But you can derive it from financial statements when you know the formula.
EBITDA = Net Income + Taxes + Interest Expense + D&A
D&A stands for depreciation and amortization. Amortization is related to intangible assets like patents, while depreciation is related to tangible assets like machinery.
D&A stands for depreciation and amortization. Amortization is related to intangible assets like patents, while depreciation is related to tangible assets like machinery.
Example
Let’s take the following example for a large UK retailer and calculate its EBITDA. It has the following figures:
- Net Income - £2,000,000
- Depreciation Expense - £1,000,000
- Amortization Expense - £500,000
- Interest Expense - £200,000
- Taxes - £300,000
Using the EBITDA formula:
- EBITDA = Net Income + Taxes + Interest Expense + D&A
- EBITDA = £2,000,000 + £1,000,000 + £500,000 + £200,000 + £300,000
- EBITDA = £4,000,000
Assuming a net income of £2 million, the EBITDA for this UK company would be £4 million. This metric reflects the company's operational profitability.
Note
Fortunately, this calculation is just for you to understand better EBITA - rather than for you to use it yourself regularly. The Trading 212 app helpfully displays the EBITA for all listed stocks, including the likes of Nvidia (NVDA).
Source: Trading 212 appEBITDA vs net income
EBITDA offers a snapshot of a company's operational profitability without accounting for financing, taxes, and non-cash expenses.
Net income reflects the total earnings after deducting all expenses, including taxes, interest, depreciation, and amortization.
Net income reflects the total earnings after deducting all expenses, including taxes, interest, depreciation, and amortization.
Example
In 2023, a large UK firm reported:
- EBITDA - £5 million
- Depreciation & Amortization - £1 million
- Interest & Taxes - £2 million
- Net Income - £2 million
EBITDA, at £5 million, indicates strong operational performance (excluding non-operating expenses).
However, after considering depreciation, amortization, interest, and taxes, the net income is £2 million. This demonstrates how operational earnings translate into actual profit after accounting for all expenses and taxes.
While EBITDA focuses solely on operational performance, net income provides a comprehensive view of a company's financial health by considering all expenses. So net income is a more complete metric to use, all things considered.
EBITDA is often used to assess core business operations and compare profitability across companies and industries, while net income is crucial for understanding the overall profitability and financial viability of a company. It’s best to look at both metrics together where possible.
However, after considering depreciation, amortization, interest, and taxes, the net income is £2 million. This demonstrates how operational earnings translate into actual profit after accounting for all expenses and taxes.
While EBITDA focuses solely on operational performance, net income provides a comprehensive view of a company's financial health by considering all expenses. So net income is a more complete metric to use, all things considered.
EBITDA is often used to assess core business operations and compare profitability across companies and industries, while net income is crucial for understanding the overall profitability and financial viability of a company. It’s best to look at both metrics together where possible.
EBITDA vs operating cash flow
EBITDA reflects a company's operating profitability by excluding interest, taxes, depreciation, and amortization expenses from its earnings. Operating Cash Flow, on the other hand, measures the cash generated or used by a company's operating activities.
Example
The following example demonstrates the difference between EBITDA and Operating Cash Flow, from a fictional company:
- EBITDA - £8 million
- Depreciation & Amortization - £2 million
- Interest & Taxes - £3 million
- Operating Cash Flow - £6 million
EBITDA, standing at £8 million, showcases the company's operational profitability before considering depreciation, amortization, interest, and taxes.
However, after accounting for these factors, the operating cash flow comes to £6 million. This indicates the real cash generated from the company's core operations, reflecting its ability to generate cash flow from its day-to-day activities.
Operating Cash Flow reflects the actual cash flow generated by the company's day-to-day operations, providing a clear picture of its liquidity and ability to meet short-term obligations.
So while EBITDA focuses on operating profitability, Operating Cash Flow measures the cash flow generated by a company's operations. This offers complementary insights into its financial health and performance.
However, after accounting for these factors, the operating cash flow comes to £6 million. This indicates the real cash generated from the company's core operations, reflecting its ability to generate cash flow from its day-to-day activities.
Operating Cash Flow reflects the actual cash flow generated by the company's day-to-day operations, providing a clear picture of its liquidity and ability to meet short-term obligations.
So while EBITDA focuses on operating profitability, Operating Cash Flow measures the cash flow generated by a company's operations. This offers complementary insights into its financial health and performance.
EBITDA vs EBIT
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIT (Earnings Before Interest and Taxes) are both financial metrics used to evaluate a company's profitability. But they differ in their scope.
EBITDA excludes depreciation and amortization expenses, as well as interest and taxes. This metric is useful for assessing a company's core operating performance, as it focuses solely on earnings generated from its primary business activities.
EBITDA excludes depreciation and amortization expenses, as well as interest and taxes. This metric is useful for assessing a company's core operating performance, as it focuses solely on earnings generated from its primary business activities.
Example
The following company has reported the following financial figures for 2023:
- Total revenue - £20 million
- Cost of goods sold - £8 million
- Operating expenses (excluding depreciation and amortization) - £5 million
- Depreciation expense - £2 million
- Amortization expense - £1 million
- Interest expense - £500,000
- Taxes - £300,000
Calculating the EBIT and EBITDA for the company is as follows:
- EBITDA = £20M (Total Revenue) - £8M (COGS) - £5M (Operating Expenses) = £7M
- EBIT = EBITDA - Depreciation - Amortization = £7M - £2M - £1M = £4M
While EBITDA is £7 million, EBIT is £4 million. This reflects the (often significant) impact of depreciation and amortization expenses on earnings.
In contrast, EBIT includes depreciation and amortization expenses but excludes interest and taxes. It represents earnings generated from operations before considering the impact of financing and taxes. EBIT provides insight into a company's operating profitability while still accounting for non-cash expenses related to asset depreciation and amortization.
In contrast, EBIT includes depreciation and amortization expenses but excludes interest and taxes. It represents earnings generated from operations before considering the impact of financing and taxes. EBIT provides insight into a company's operating profitability while still accounting for non-cash expenses related to asset depreciation and amortization.
How to differentiate between good and bad EBITDA?
EBITDA is not merely a numerical value that you can look at. Differentiating between good/ bad EBITDA involves considering a number of criteria:
- Industry norms - Compare EBITDA with industry averages to assess relative performance.
- Consistency - Consistent EBITDA growth or stability indicates healthy operational performance.
- Quality of earnings - Evaluate the sustainability of EBITDA by examining revenue sources and cost structures.
- Cash flow - Assess if EBITDA translates into strong cash flow and liquidity.
- Growth potential - Consider if EBITDA growth aligns with the company's growth strategy and market opportunities.
- Management integrity - Scrutinise for potential EBITDA manipulation or aggressive accounting practices.
- Debt levels - Analyse EBITDA in relation to debt levels to gauge financial leverage and risk.
- Market conditions - Consider economic factors and market trends impacting EBITDA performance.
The bullets above should give you a fairly good indication as to the downfalls of EBITDA. If you merely take the numerical value, you could easily be misled, and many dishonest companies are aware of this fact.
Overall, a combination of financial analysis, industry context, and qualitative factors helps determine whether EBITDA genuinely reflects a company's operational performance or masks underlying issues.
Overall, a combination of financial analysis, industry context, and qualitative factors helps determine whether EBITDA genuinely reflects a company's operational performance or masks underlying issues.
Calculating EV/EBITDA multiples
EV/EBITDA multiples, or Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization multiples, are a valuation metric used by investors and analysts to assess the value of a company relative to its earnings before certain expenses.
The enterprise value (EV) represents the total value of a company's equity and debt, accounting for cash and investments. EBITDA, or earnings before interest, taxes, depreciation, and amortization, reflects a company's operational profitability before accounting for certain expenses.
The enterprise value (EV) represents the total value of a company's equity and debt, accounting for cash and investments. EBITDA, or earnings before interest, taxes, depreciation, and amortization, reflects a company's operational profitability before accounting for certain expenses.
Example
Let's take a company, with an enterprise value of £50 million and EBITDA of £10 million. To calculate the EV/EBITDA multiple:
EV/EBITDA = Enterprise Value / EBITDA
EV/EBITDA = £50,000,000 / £10,000,000
EV/EBITDA = 5x
This means that the company’s valuation is 5x its EBITDA. Investors and analysts use EV/EBITDA multiples to compare the valuation of different companies within the same industry. Or, to assess a company's valuation relative to historical performance or industry averages.
A higher multiple may indicate that a company is overvalued, while a lower multiple may suggest that it is undervalued. Other factors should be considered in conjunction with the multiple for a well-rounded valuation.
EV/EBITDA = Enterprise Value / EBITDA
EV/EBITDA = £50,000,000 / £10,000,000
EV/EBITDA = 5x
This means that the company’s valuation is 5x its EBITDA. Investors and analysts use EV/EBITDA multiples to compare the valuation of different companies within the same industry. Or, to assess a company's valuation relative to historical performance or industry averages.
A higher multiple may indicate that a company is overvalued, while a lower multiple may suggest that it is undervalued. Other factors should be considered in conjunction with the multiple for a well-rounded valuation.
Advantages of EBITDA margin
The EBITDA margin can provide some of the following benefits:
✔️ Provides insight into operational profitability
Excludes non-operating expenses and accounting decisions
✔️ Facilitates comparison across companies and industries
✔️ Helps evaluate operational efficiency and performance
✔️ Offers a clearer view of a company's core business activities
✔️ Provides insight into operational profitability
Excludes non-operating expenses and accounting decisions
✔️ Facilitates comparison across companies and industries
✔️ Helps evaluate operational efficiency and performance
✔️ Offers a clearer view of a company's core business activities
Disadvantages of EBITDA margin
EBITDA has come under fire from Warren Buffett and many other prominent investors. Some of the pitfalls of EBITDA margin are as follows:
❌ May overlook important expenses like capital expenditures
❌ Excludes taxes and interest, which are essential financial considerations
❌ Can be manipulated by management through accounting decisions
❌ Ignores changes in working capital, impacting cash flow analysis
❌ Does not reflect the true cost structure or long-term financial health
❌ May overlook important expenses like capital expenditures
❌ Excludes taxes and interest, which are essential financial considerations
❌ Can be manipulated by management through accounting decisions
❌ Ignores changes in working capital, impacting cash flow analysis
❌ Does not reflect the true cost structure or long-term financial health
Industry EBITDA benchmarks
The following short table showcases how the average EBITDA margin can change per industry. Interestingly, the biotechnology sector has a massive negative EBITDA. Correctly evaluating companies with a negative EBITDA is a little more complicated - it does not automatically mean they are going to fail.
Industry | Average EBITDA margin | Number of companies |
Advertising agencies | 5.9% | 22 |
Aerospace & defense | 10.3% | 49 |
Agricultural Inputs | 13.6% | 11 |
Airlines | 9.2% | 13 |
Apparel manufacturing | 8.6% | 17 |
Apparel retail | 10.1% | 28 |
Asset management | 42.1% | 72 |
Auto manufacturers | 11.5% | 15 |
Auto parts | 8.4% | 46 |
Auto & truck dealerships | 7.3% | 14 |
Banks - diversified | 35.8% | 6 |
Banks - regional | 36.1% | 276 |
Beverages - non-alcoholic | 18.5% | 9 |
Beverages - wineries & distilleries | 21.7% | 9 |
Biotechnology | -205.5% | 504 |
Source: Full Ratio
Recap
EBITDA has been criticized by many investors as giving a flawed perception of company value. Most high-value companies (Walmart, GE, Microsoft) don’t use EBITDA in their reports. So the metric can be used as a tool for misleading investors - and it has been.
However, it’s only an issue when you are not familiar with what it represents. In particular, the metric is useful for investment firms that have strong accounting and financial teams. Such firms can readily deal with issues relating to interest expense, taxes, depreciation, and amortization.
Other than this, believing that EBITDA represents company profitability is not accurate. The items that it excludes are not trivial and have a significant impact on performance.
However, it’s only an issue when you are not familiar with what it represents. In particular, the metric is useful for investment firms that have strong accounting and financial teams. Such firms can readily deal with issues relating to interest expense, taxes, depreciation, and amortization.
Other than this, believing that EBITDA represents company profitability is not accurate. The items that it excludes are not trivial and have a significant impact on performance.
FAQ
Q: How is EBITDA calculated?
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is calculated by adding back interest, taxes, depreciation, and amortization expenses to net income. This provides a clearer picture of a company's operational performance by excluding non-operating expenses and accounting decisions. It's a widely used metric for evaluating a company's profitability and financial health.
Q: Is EBITDA the same as gross profit?
EBITDA differs from gross profit in that it includes all operating expenses except for interest, taxes, depreciation, and amortization. While gross profit only considers the cost of goods sold, EBITDA provides a broader view of a company's profitability by incorporating all operating expenses.
Q: What does EBITDA really tell you?
EBITDA offers insights into a company's operational efficiency and profitability by focusing on its core business activities. It helps investors assess a company's ability to generate cash flow from its operations, independent of financing and accounting decisions. However, it's important to supplement EBITDA analysis with other financial metrics for a comprehensive evaluation of a company's financial health.
Q: What is a good EBITDA?
A good EBITDA depends on various factors such as industry norms, company size, and growth stage. Generally, a higher EBITDA indicates better operational performance and profitability. However, what constitutes a "good" EBITDA can vary significantly between industries and individual companies.
Q: Why is EBITDA so important?
EBITDA is important because it provides a clearer picture of a company's underlying operational performance by excluding non-operating expenses and accounting decisions. It helps investors assess a company's ability to generate cash flow from its core business activities, which is crucial for evaluating its financial health and potential for long-term growth.
Q: How is the EBITDA margin calculated?
The EBITDA margin is calculated by dividing EBITDA by total revenue and multiplying by 100 to express it as a percentage. It measures a company's operational efficiency and profitability as related to its total revenue. A higher EBITDA margin indicates that a company is generating more earnings from its core business activities.
Q: How reliable is EBITDA?
The reliability of EBITDA as a financial metric depends on how it's used and interpreted. While EBITDA provides insights into a company's operational performance, it has limitations and should not be viewed in isolation. Investors should consider other financial metrics and qualitative factors to understand a company's financial position. EBITDA can be manipulated by management through accounting decisions - so it's essential to scrutinize its calculation and context as carefully as possible.
