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If Company A had earnings of EUR 5 million, operating expenses of EUR 1 million, and amortisation and depreciation totalling EUR 250,000, its earnings before interest and taxation (EBIT) would be EUR 3.75 million. If Company A’s interest totalled EUR 200,000, its pre-tax earnings would be EUR 3.55 million. If its annual taxes totalled EUR 400,000, its net income is EUR 3.15 million.
From these numbers, we can start with the operating income of EUR 3.75 million (note that in some cases, EBIT and operating income can differ, but they’re equivalent in our example). Add back amortisation and depreciation for an EBITDA of EUR4 million.
To use the second calculation instead, we would take the net income of EUR 3.15 million and add back taxes (EUR 400,000), interest (EUR 200,000), and amortisation and depreciation (EUR 250,000) for an EBITDA of EUR 4 million.
EBITDA and operating cash flow are often mistaken for one another when reporting a company’s revenue. People often use the EBITDA value when talking about a company’s cash flow, but there are several differences between the two.
In broad terms, operating cash flow represents the money flowing in and out of a company. Operating cash flow is determined by combining depreciation and amortisation with net income while factoring in any adjustments within accounts payable and receivable.
While EBITDA also adds depreciation and amortisation back into its final calculations, it doesn’t take taxes or interest into the equation. These are essential for operating cash flow as they are considered cash outflows.
Both EBITDA and operating cash flow are popular metrics for gauging how effective a company is at generating income through its primary services. It’s important to know what is included in the figure you are reviewing to ensure you make informed judgements when analysing a company.
EBITDA was first used by an entrepreneur named John C. Malone. A former CEO and president of Tele-Communications Inc., Malone honed this business metric to show the cash-generating potential of telecommunications firms.
Malone believed the best way of optimising the earnings per share of his company for shareholders flew in the face of his telecoms company’s ambition to scale. In Malone’s view, bigger net incomes led to greater taxation. Instead, he sought to minimise reported earnings and taxes, allowing his company to invest in growth and engage in mergers and acquisitions using pre-tax cash flows.
Hence, the metric of EBITDA was born: a “pure” income figure for a business to highlight its cash-generating potential.
What are some of the advantages and disadvantages of using EBITDA to determine the value and potential of businesses you’re thinking of investing in?
Some investors will also look at the enterprise value (EV) of a company compared to its EBITDA to determine if a stock is undervalued. EV/EBITDA is displayed as a valuation multiple to define a fair market price for a company. Historically speaking, companies with EV/EBITDA multiples of less than ten are attractive to value-seekers.