What is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s financial health and earnings potential from core business operations. Its purpose is to give investors a better idea of how much a business earned from its actual business operations. Since interest, taxes, depreciation, and amortization are mostly unique events that have little to do with the underlying business, its often more useful to look at EBITDA numbers than overall net earnings.
To calculate EBITDA, you need to know some basic information that you can find on just about any corporate income statement or balance sheet. This is the most simple way to calculate EBITDA:
- EBITDA = Operating Profit + Depreciation Expense + Amortization Expense
Alternatively, you can also use this method. However, it requires more data inputs:
- EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Whichever form you prefer, they both will take you to the same destination. Stripping out extraneous factors allows traders to see how the core business is operating. The downside is that is doesn’t speak for management. Core businesses can be performing well while companies decline due to poor management. Like any other data point, EBITDA is most effective when used in conjunction with other types of analysis.
Why is EBITDA Useful?
Traders can use it to help identify whether or not a core business is performing well. This form of earnings strips extraordinary expenses and allows for better baseline comparison of the underlying business model. Comparing stocks using EBITDA numbers allows traders to look at the companies in a more objective way because it compares actual underlying business operations. Traders frequently used this figure to measure corporate profitability, and it’s also used to estimate incoming cash flow and a company’s ability to cover its long-term debts. Many traders prefer to use EBITDA when comparing different companies with sector benchmarks because they offer a more objective view of a company’s business.
Discovering the information you need to perform this calculation is easy. You can find the required data in a company’s income statement under selling, general, and administrative expenses (SG&A). This category includes depreciation and amortization expenses.
How To Use It
EBITDA helps interested parties evaluate similar companies in their respective business. Differences in companies’ accounting practices cause differences in net income earned. However, this is not to say that the company is a standout or a laggard. This information alone cannot tell investors how the company is doing relative to its peers.
This form of earnings measurement first gained notoriety amongst leveraged buyout investors in the 1980’s, and it’s been hanging around ever since. The metric became popular as a means for finding companies with good underlying businesses and bad balance sheets, two attributes of an excellent distressed debt trade. These days, EBITDA is as popular as ever. Traders still use it to evaluate distressed debt, make apples-to-apples comparisons of different businesses, and compare potential investments to sector bench
Generally accepted accounting principles (GAAP) do not cover EBITDA statements. As a result, the way companies calculate EBITDA varies from one company to the next. Many companies will emphasize the EBITDA ahead of their net earnings, but this could be a red flag. Sometimes, companies will emphasize the earnings before interest, taxes, depreciation, and amortization figures ahead of net income so they can disguise or distract from inherent problems with the business.
If a company starts to prominently report EBITDA after not regularly doing so in the past, it’s a potential omen of bad things to come. Companies that borrow heavily or have problems with rising capital costs, may begin to emphasize these types of unregulated earnings figures over the more strictly regulated net income numbers. If you see a company suddenly shift towards non-GAAP earnings figures on their quarterly earnings report, it’s very often a bad sign and – at the very least – it’s worth looking into.
In conclusion, knowing and understanding EBIDTA is essential in analyzing companies. Not knowing this measure makes comparing similar companies difficult. Estimating the fair value for stocks relies on this at its core.
Interest is largely a management choice- a financing decision. Financing decisions are not directly correlated with market demand for products. Also, market demand and growth ultimately decide the analyst’s predictions of stock prices. Any successful form of market analysis or company analysis includes an understanding of EBITDA.