What Is EBITDA?

Before buying a stock, it’s critical to ascertain what level of profits it generates. Sounds obvious, right?

Looking at a firm’s profitability can provide an indication of future dividend levels. It also helps us to assess what a company is worth and the scope for share price gains.

EBITDA is a helpful metric to do that. But what does it mean and how do you calculate it? Let’s break it down.

What is EBITDA?

EBITDA is a popular way to calculate profitability of a company. It stands for earnings before interest, tax, depreciation, and amortisation.

The interest and the tax parts are simple. They refer to the costs a firm pays on its debt, and the contribution it pays to governments based on its earnings, respectively.

Depreciation is an accounting process that addresses the erosion in the value of fixed assets over time due to items like wear and tear.

Amortisation, meanwhile, is another accounting technique that reflects the cost of an asset over time to a business. Amortisation covers intangible assets like trademarks and patents.

The EBITDA formula is a non-standardised way of calculating a company’s earnings. It is designed to give a business more flexibility when reporting performance than generally accepted accounting principles (or GAAP) allow.

Companies who use EBITDA say that it gives a more accurate indication of earnings power. By stripping out tax costs and interest payments it puts greater emphasis on the nuts and bolts of the business.

How to calculate EBITDA

EBITDA is simple to calculate. The first thing to do is to locate total revenue and then remove operating expenses, depreciation, and amortisation. This will reveal a company’s operating profit (otherwise known as earnings before interest and tax, or EBIT for short).

Then interest payments are deducted to produce pre-tax profit. The removal of the tax charge from this then creates net profit.

The final step is to work out the actual EBITDA. To do this we add operating profit to the depreciation and amortisation expenses.

This information can all be found in a company’s half-year or full-year update listed on the London Stock Exchange.

What does EBITDA tell you?

EBITDA can be useful when comparing the underlying performance of two different companies.

As it removes tax and debt expenses, along with depreciation and amortisation, this metric makes it simpler to assess profitability by basing it just on a company’s operations. A business with higher earnings versus another would be considered more valuable.

The EBITDA formula can also be used to work out how a firm’s capital structure can affect its cash flows.

However, because of its limitations it should be used alongside other metrics to gauge a company’s profitability.

An example of EBITDA

Now let us see how EBITDA can be used to compare two different companies. We’ll say that both are in the cupcake-manufacturing business.

The main difference between these baking firms is their capital structure. ‘Top Cupcakes’ was funded by equity, while ‘Cupcake World’ took on debt to finance its operations. Last year’s income statements for both firms are below:

Top Cupcakes

Last year, Top Cupcakes reported EBITDA of £600,000 (£540,000 + £50,000 + £10,000).

Cupcake World

Last year, Cupcake World and Top Cupcakes reported identical EBITDA of £600,000.

But as you can see, Cupcake World’s debt obligations of £150,000 meant that its net profit was far lower. This came in at £315,900 versus its rival’s £437,400.

This example reveals the benefit of using the EBITDA formula. It allows us to effectively look at the underlying profitability of two comparable businesses. And it lets us consider a company’s actual profits when its capital structure and taxes are considered.

So which one of Top Cupcakes and Cupcake World be worth more to investors? The answer is Top Cupcakes, as it’s able to convert more of its EBITDA into net profit. As a consequence, one would also expect it to carry a higher share price than Cupcake World.

What is a good EBITDA margin?

The EBITDA margin is a tool that measures a company’s operating profit in proportion to its revenues. It’s a useful way to ascertain the impact that operating expenses have on the bottom line.

An EBITDA margin of 10% or above can be regarded as good. The higher the reading, the lower the risk.

To continue with the last example, let’s calculate the EBITDA margin of Top Cupcakes and Cupcake World. Both have reported earnings of £1,000,000 for last year and EBIDTA of £600,000. As a result, their margins came in at 60%.

The drawbacks of EBITDA

The trouble with EBITDA is that it precludes important information that affects company profitability.

It doesn’t consider other key information that can be critical in an investor’s decision-making process, such as the way a company employs debt, cash, equity, and other methods of capital to carry out its operations. It also doesn’t reflect the impact of tax, an expense that can change markedly from year to year and have a significant impact on earnings.

Finally, EBITDA fails to account for depreciation, a critical tool in valuing a company by getting an accurate idea of what its fixed assets are worth.

Criticisms of EBITDA

Critics of EBITDA often complain that the metric can also be used to conceal key financial information. Some even refer to EBITDA under another acronym: ‘earnings before I tricked the dumb auditor!’

Billionaire investor Warren Buffett certainly isn’t a fan of using EBITDA to gauge a company’s performance. 

“References to EBITDA make us shudder”, the Berkshire Hathawayboss said in his investment firm’s 2000 annual report. “Does management think the tooth fairy pays for capital expenditures?”

The Sage of Omaha added that “we’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.”¹

Buffett hasn’t changed his view in the 20-plus years since then, either.

Should you use EBITDA?

Like most things in investing, looking at just one metric isn’t a good idea. EBITDA, if used in isolation, can give a distorted impression of a company’s investment case.

However, when used alongside other metrics, EBITDA can help investors make sensible decisions.