What is EBITDA and how is it used in investing?

What is EBITDA?

EBITDA is short for earnings before interest, taxes, depreciation, and amortisation. It is an earnings metric often used to compare operating performance between companies in the same industry before financing costs, taxes and certain non-cash accounting charges. However, comparisons still need context because accounting policies, capital intensity, lease treatment and business models can differ. EBITDA is not cash flow and does not directly reflect capital structure.

When using EBITDA in valuation, remember that it excludes interest, taxes, depreciation and amortisation. This means it does not reflect financing costs, tax position, capital expenditure requirements, or working capital movements. Taxes and interest depend on factors such as jurisdiction, financing choices, and market rates, while depreciation and amortisation depend on accounting policies, the asset base, and investment decisions. For example, depreciation allocates an asset’s cost over its useful life based on assumptions such as useful life and residual value.

How do you calculate EBITDA?

Calculating EBITDA is straightforward. You can find all the information needed for EBITDA calculations on a company’s income statement (and the notes), and sometimes the cash flow statement for depreciation/amortisation. The two common ways to calculate EBITDA are:

Net income + interest + taxes + depreciation + amortisation

Operating income + depreciation + amortisation

In other words, EBITDA can be calculated by starting with net income and adding back interest, taxes, depreciation and amortisation. These items are added back because they have already been deducted when arriving at net income. Another common method is to start with operating income and add back 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 typically excludes or normalises certain items (often described as ‘one-off’ or non-recurring), but definitions vary and adjustments can materially change the figure.

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

In mergers and acquisitions, EBITDA is often used as one input when comparing companies and estimating valuation multiples, such as enterprise value to EBITDA. Many valuation specialists use EBITDA alongside revenue, margins, cash flow, debt, capital expenditure needs and peer comparisons before a merger or acquisition.

This is useful because a buyer or investor will usually want to understand how a company performs relative to similar businesses. EBITDA alone does not show whether a company is attractive or fairly valued.

Business owners may also use EBITDA when preparing for a sale. Likewise, investors may review a company’s EBITDA alongside valuation measures and other fundamentals before buying its shares.

Low EBITDA margins can indicate weaker operating profitability relative to peers, but they can also reflect industry structure, investment phase, or differences in accounting and adjustments.

Financial institutions

Lenders may use EBITDA in ratios such as debt-to-EBITDA or interest coverage to assess debt capacity and covenant compliance. However, EBITDA is not the same as cash flow, so lenders also consider operating cash flow, capital expenditure, working capital, interest costs and debt maturities.

Financial institutions may also use EBITDA-based thresholds in loan covenants.

Debt covenants are conditions included in loan agreements. They may include financial measures, such as maintaining a minimum interest coverage ratio or staying below a maximum leverage ratio, as well as restrictions on actions such as additional borrowing, asset sales or dividend payments while the loan is outstanding.

Risks and considerations to be aware of 

Before using EBITDA to assess profitability and financial performance, it is important to understand its drawbacks. EBITDA is not a standard GAAP or IFRS line item, and calculations can vary between companies. Some companies also highlight adjusted EBITDA figures that exclude costs investors may still consider relevant. Other drawbacks include: 

EBITDA can be calculated from different starting points, which may affect comparability.

EBITDA-based valuation multiples can make companies look cheaper than metrics that include depreciation, amortisation, interest or taxes.

EBITDA ignores capital expenditure needs and working-capital movements.

EBITDA vs. operating cash flow

EBITDA can be a convenient metric because it is relatively straightforward to calculate and widely used in company comparisons. However, operating cash flow can provide a more direct view of the cash a business generates from its core operations because it reflects working capital changes, such as receivables, payables, and inventory.

EBITDA can be useful for comparing operating performance, but it excludes factors such as working capital, capital expenditure requirements, interest, taxes, depreciation, and amortisation. For that reason, investors often compare EBITDA with operating cash flow, free cash flow, margins, debt levels and valuation multiples.

Financial platforms may provide EBITDA, cash flow data, and other measures, but these figures should be reviewed together and checked against company reports where possible.