What is EBITDA and how is it used in investing?

What is EBITDA? 

EBITDA is short for earnings before interest, taxes, depreciation, and amortisation. EBITDA is an earnings metric that lets you compare industry averages and company performances between two or more organisations in different locations. It helps you understand a company's capital structure and how it affects cash flow. 

When using EBITDA to understand a company's valuation, remember that the earnings metric doesn’t account for how businesses use capital sources like cash, equity, and debt to finance their operations. EBITDA also excludes taxes and non-cash expenses, such as depreciation. These are all factors that can manipulate earnings. 

Taxes, interest, amortisation, and depreciation are factors out of a company’s control. For example, depreciation looks at inflation and other economic conditions and reduces the value of a company’s assets based on these external factors. 

Economic conditions like inflation hold powerful influence across the financial industry, impacting everything from the price of oil to the value of stock market indexes like The Dow Jones Industrial Average (DJIA). 

How do you calculate EBITDA?

Calculating EBITDA is straightforward. You can find all the information needed for EBITDA calculations on a company’s balance sheet or income statement. The two ways to calculate EBITDA include: 

Adding net income, taxes, and interest with amortisation and depreciation 

Adding operating income with depreciation and amortisation 

Let’s look at an example of calculating a company’s EBITDA using the first method (with net income). Gateway Health is a fictional pharmaceutical company that provided the following figures in its income statement for one year ending December 31: 

Net income: $822,451 

Income taxes: $21,350 

Interest: $101,500 

Depreciation and amortisation: $125,000 

Using the first method of calculating EBITDA, you would add back Gateway Health’s depreciation and amortisation figure to its net income, income taxes, and interest to equal an EBITDA of $1,070,301. 

Be aware there is a difference between EBITDA and adjusted EBITDA. Adjusted EBITDA includes material items and additional expenses like stock issuance. It also includes nonrecurring expenses. 

How is it used in investing? 

Business valuators and financial institutions use EBITDA to compare companies and industry averages. Here’s an overview of how each uses the earnings metric: 

Business valuators 

Business mergers and acquisitions happen all the time, but how do you know what companies are worth pursuing and acquiring? Well, that’s one of the main functions of EBITDA. Many business valuators (trained specialists who analyse and value companies) use EBITDA to calculate a company’s valuation ahead of a merger or acquisition. 

This is crucial because you want to know how a company performs compared to its rivals before acquiring it. After finding out a company’s EBITDA, you may want to look at other, more profitable options. 

Entrepreneurs also conduct EBITDA calculations for business sales. Likewise, investors can calculate a company’s EBITDA before investing in its stock. For example, you don’t want to invest in an ESG company’s stock when it has a poor valuation and a low EBITDA. Generally speaking, low EBITDA margins suggest a company has cash flow or profitability problems. 

Financial institutions

Bankers use EBITDA for several reasons. First, they use the earnings metric to calculate a business’ debt coverage ratio. Second, bankers use EBITDA to see how much cash flow a company has available. 

Whatever this figure is will indicate to bankers if businesses can pay for long-term debt or not. You may also see some financial institutions using EBITDA as part of a debt covenant. 

Debt covenants are promises you make to lenders as part of your loan agreements. Common debt covenants include hard financial measures (actions you must meet) and keep-well clauses. Keep-well clauses refer to what companies do (or do not do) while their loan is outstanding. 

For example, you can’t incur any additional debt while your loan is outstanding, and you must keep the same management team in place for the loan’s duration.

Risks and considerations to be aware of 

Before using EBITDA to measure a company’s profitability and financial performance, you should know its drawbacks. One common criticism of EBITDA is that because it’s a non-GAAP measure, EBITDA calculations vary between companies. Some businesses also use EBITDA to distract investors when they are experiencing increasing development costs and capital. Other drawbacks of EBITDA include: 

EBITDA has different starting points 

EBITDA makes a company’s valuation look less expensive than it is 

EBITDA ignores the cost of assets and working capital 

What’s better? EBITDA or operating cash flow?

EBITDA is a convenient tool if you’re looking for a performance metric that’s straightforward to calculate. However, other financial measures have advantages over EBITDA, such as operating cash flow.

In general, operating cash flow provides a more accurate measure of a company’s valuation and how much cash they are generating, because it includes changes in working capital. When you don’t include working capital, such as changes in payables and receivables, you may miss key evidence showing an organisation is struggling with cash flow.

EBIDTA is a good measure of how a company is performing. However, because it leaves out crucial factors like working capital, do additional research on how much cash a company is generating.

You can use different trading platforms to make informed investment decisions and use other measures like operating cash flow to compile an even more comprehensive overview of how a company's performing. 

Key takeaways

• EBITDA is a metric used to measure a company’s profitability and financial performance
• The metric became popular in the 1980s and during the Dot-com bubble 
• EBITDA doesn’t account for how businesses use capital sources like debt and excludes tax and non-cash expenses like depreciation 
• There are two ways to calculate EBITDA. The first uses net income, and the second uses operating income 
• Business valuators, entrepreneurs and financial institutions like banks use EBIDTA to gauge a company’s profitability 
• Even though EBIDTA helps provide perspective and it’s easy to calculate, the metric does have drawbacks 
• Common criticisms of EBIDTA is that the metric can make a company look less expensive than it is 
• EBIDTA also doesn’t consider working capital, which can misconstrue the overall picture of how much cash a company is generating 
• Operating cash flow is a better measure of profitability than EBIDTA