Earnings before Interest, Taxes, Depreciation, and Amortization
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EBITDA «ee-bit-dah» or «ee-bit-dee-eh» is an acronym for Earnings before Interest, Taxes, Depreciation, and Amortization. The same calculation can be arrived at from "operating income before depreciation and amortization" (OIBDA). It is one measure of 'operating cash flow'.
It differs from the cash flow from operations found in the Statement of Cash Flow primarily by ignoring payments for taxes or interest. EBITDA does not add back many of the other non-cash operating expenses, like the Statement of Cash Flow does. EBITDA also differs from free cash flow because of the difference above, and also because it does not recognize the cash requirements for replacing capital assets.
Although there are different POVs regarding the use of this metric by equity owners, most everyone agrees to its validity when used by debtholders, or to evaluate a business's ability to handle debt.
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[edit] Use by debtholders
The holder of debt is concerned with the business's ability to pay the interest and to repay the principal when due. Since interest is paid before income tax is calculated, it has no interest in taxes. The debtholder is not interested in whether the business can replace its assets when they wear out, so he can ignore both capital expenditures and their amortization. EBITDA measures the cash earnings that he can expect to be applied to interest and debt retirement.
There are two EBITDA metrics used.
- The interest coverage ratio is used to determine a firm's ability to pay interest on outstanding debt. It is calculated : EBITDA /Interest Expense. The greater the year-to-year variance in EBITDA, the greater the multiple should be.
- The measure of the pay-back period for a debt is : Debt/EBITDA. The longer the payback period, the greater the risk.
The ratios can be customized by reducing Debt by any cash on the balance sheet or by deducting maintenance capx from EBITDA to form a measure closer to free cash flow.
[edit] Use by equity owners - Pro
A backronym variation of the term is "Earning before I tricked the dumb auditor."
Depreciation
A company's Net Income is distorted by decisions that the company made in previous years. This is because of the differences between accrual accounting and cash basis accounting. Some purchases are depreciated or amortized over 20 years or more, with a negative impact on the Net Income long after the actual financial effects of the purchases have ceased. The EBITDA does not suffer this distortion, so investors can get a better idea of how profitable the company really is
Depreciation of capital expenditures is a particularly strong factor. For example, if a company spends $99 million in new desktop computers for all its employees, the company will often decide to depreciate the purchase over their expected lifetime of three years. This way, in the first year, when the company calculates its "income" number, it pretends that it has only spent $33 million that year on desktop computers. The company's income number paints a more rosy and optimistic picture than actually occurred that year. In each of the second and third years, the company also pretends that it has spent $33 million per year on desktop computers. Hence, the company's financial picture was probably healthier than indicated by the income number, since the $33 million had actually already been paid out.
Capital expenditures typically vary from year to year. Accrual accounting accounts for this by spreading the expense of capital investments over the years in which they will be generating value for the company. EBITDA removes this effect. Investors can use EBITDA to approximate the fundamental earning power of the company's operations while separately factoring in the projected capital expenditures needed to maintain those operations. This is valuable because of the time value of money principle. (An expenditure is less costly if it is to be made several years into the future, because during the interim period the firm can use the cash for that expenditure to generate income in other ways.)
Interest
Because EBITDA is measured before interest (which vary with the amount of debt financing), it approximates the company's earnings potential as if financed with zero debt. It corrects for the differences between companys' valuations due to their capital structure. If the investor can change the capital structure of a firm (e.g., through a leveraged buyout) he first evaluates a firm's fundamental earnings potential (reflected by EBITDA or EBIT), and then determines the optimal use of debt vs. equity.
[edit] Use by equity owners - Con
In layman's terms, EBITDA is called "Earnings, before all the bad stuff". Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?" People who understand the how's and why's of accounting think that Net Income is a better measure of a business' performance than EBITDA.
The basic debate over the value of accrual vs. cash accounting comes down to the question. "When you bought your Christmas presents in December 2001, did you consider them to be a 2001 expense? Or did you consider them to only show up in 2002 when you made the January credit card payment? Most people acknowledge the costs in 2001, even though there was no cash transaction.
Depreciation
The same argument applies to the purchase of long-life capital assets. You can consider depreciation to be either:
- the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time-value-of-money (same argument used above) means that the depreciation UNDERSTATES the cost.
- the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflations is the basis for time-value-of-money, the amounts set aside today must be invested and grow in value in order to pay the inflated price in the future. Or
- the decrease in value of the balance sheet asset since the last reporting period. Assets wear out with use. A company with old assets is not worth as much as a company with new ones.
No matter which POV you choose, non-cash expenses are 'real' costs. This amount of cash received from sales is only a return of capital. See return of capital for detailed explanation.
No matter that the proponents of EBITDA claim to separately consider the future requirements for capital asset replacements, none due in public. When management is free to create their own estimate, their numbers are never justified with details and always low-balled beyond belief. Depreciation is not an exact measure, but it is beyond management manipulation, and supported by disclosed math calculations.
Interest
The only reason to ignore interest and financing expenses is if the investor CAN in fact create his own personal leverage that will equalize the leverage between different investments. No investors can. In the big picture, investors lever their portfolio, not individual stock positions. Even if long-term leverage could be equalized, most businesses use extensive short term debt to finance 1-2-3 month cash requirements. The investor can never replicate these cash flows.
If the investor separately measures the company's leverage and combines this metric with EBITDA, it would be valid. But leverage rates are rarely quoted in the media. Even sophisticated investors do not know how to weigh the trade-offs between the two metrics.
Taxes
There is no excuse for ignoring taxes. Management is payed to manage taxes, just like other expenses. This is why they incorporate in tax havens. The less money going to taxes, the more is left for equity owners.
Manipulation
The major argument for EBITDA is that is beyond management manipulation. Yet once management is told this is the metric they will be judged by, they immediately find ways to manipulate it. See cash flow for a list of simple and ubiquitous ways to do this.
[edit] Unprofitable businesses
When comparing businesses with no profits, their potential to make profit is more important than their Net Loss. Since taxes on losses will be misleading in this context, taxes can be ignored. Capital expenditures and their related debt result in fixed costs. These are of less importance than the variable costs that can be expected to grow with increasing sales volume, in order to cover the fixed costs. So depreciation and interest costs are of less importance. It is likely than an unprofitable business is burning cash (has a negative cash flow), so investors are most concerned with "how long the cash will last before the business must get more financing" (resulting in debt or equity dilution). For these reasons EBITDA is the metric most appropriate.
Be clear that EBITDA is not used as a valuation metric in these circumstances. It is a starting point on which future growth is applied and future profitability discounted back to the present. Equity owners only benefit from net profits, after all the expenses are paid.
During the dot com bubble companies promoted their stock by emphasizing either EBITDA or pro forma earnings in their financial reports, and explaining away the (often poor) "income" number. This would involve ignoring one-time write-offs, asset impairments and other costs deemed to be non-recurring. Because EBITDA (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.
A negative EBITDA figure is not meaningful when consideration valuation multiples (namely Enterprise Value/EBITDA).
