How to Calculate EBITDA and Why is it so Important?

date: 2021-06-13 21:31:31

 

Most people who have a high-level understanding of finance and investments should have come across the term “EBITDA”. So, what is EBITDA? EBITDA is an abbreviation of Earnings before interest (loan interest payments and interest revenue), tax (income tax), depreciation and amortization (which is the amount expensed as a result of your assets being depreciated / amortized).

It is calculated by taking the net profit and removing interest expenses / revenue, income tax, depreciation & amortization as well as any other non-operating revenue/expense.

EBITDA is one of the most widely used terms in finance, especially in valuations. This is because EBITDA assists in understanding a company’s operational profitability / loss, by taking away all “non-operating” revenue and expenses. It is so widely used that most companies report it in their earnings fillings, although it is not officially required by most accounting policies.

 

Best Operating Metric?

EBITDA solely focuses on the operating revenue (non-operating revenue should be excluded in the EBITDA calculation), operating expenses, which includes cost of services/goods sold, sales and marketing expenses and general and administrative expenses. In a nutshell, EBITDA is supposed to reflect the pure operating performance of any company.

The best argument for EBITDA is that it provides a clean metric by excluding the impact of capital structure (if a company has a high debt to equity ratio then high interest expenses will be paid), tax policies (given that it could differ from one company/country to another), depreciation and amortization (given that is a non cash flow item) and difference in accounting policies.

For example, looking at the  percentage of income tax paid by USA’s top 10 firms during 2017,. the percentage of cash tax payments ranged between 15%-40% so if net profit or cash flow were used as the sole metric your analysis would have been affected.

 

However, given it’s large usage, EBITDA has had several critics. For example, Warren Buffet himself stated that “When CEOs uses EBITDA as a valuation guide, wire them up for a polygraph test”. Why? Well mainly because EBITDA does not take into consideration the “expense” of purchasing / selling assets (i.e. capital expenditures) and for that Warren Buffet also states “When Charlie and I read reports…references to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something”. 

So, let us understand the problem and the options available, because if EBITDA has the problem of not taking into account capital expenditures, so what is the better solution?

In reality, there is no better solution, each metric has its own disadvantages. However, relying on only one metric is never correct and, in that sense, more than one metric should always be taken into consideration when valuing or analysing a company and additionally, you need to understand the disadvantage of each metric. 

For example, let us analyse the most popular valuation methodologies and understand the advantage and disadvantage of each metric, as per UBS and Macabus:

MetricAdvantageDisadvantage
Enterprise Value ("EV")/Sales or Price/Sales

Used to value businesses with negative EBITDA and less susceptible to manipulation and accounting shenanigans

Can be used to calculate both enterprise and equity value of the business

Ignores profitability of the business which is the basis for valuation

Inaccurate in several cases, given the uncertainty on future profitability of loss-making businesses

EV/EBITDA

Earnings and cash flows proxy for businesses

Values the enterprise independent of capital structure

Doesn’t take into account taxes, depreciation expenses, and capital expenditures
EV/EBIT (Earnings Before Interest and Taxes)

Earnings and cash flows proxy for businesses

Values the enterprise independent of capital structure

Doesn’t take into account taxes and capital expenditures

Depreciation subject to accounting policies could be prone to manipulation

Price/Earnings

One of the easiest metrics to value a business

Directly calculates the equity value for the business

Doesn’t accurately reflect the profitability of the business

Prone to manipulation given the impact of one-off expenses, accounting policies, and taxes

Price/Book

One of the easiest metrics to value a business

Directly calculates the equity value for the business

Doesn’t accurately reflect the profitability of the business

Infrequently used as a methodology in the current environment

Discounted Cash Flows (“DCF”)

Most comprehensive method to value a business

Can be used to calculate both enterprise and equity value of the business

Highly sensitive to terminal growth and cost of capital assumptions

Inaccurate in most cases given the length of the projection period

A conclusion from the above is that EBITDA has disadvantages, however, in Finance, when comparing all metrics together, it is better than all the other alternatives. 

 

Summary

In summary, EBITDA does have some disadvantages, however, it is the best metric available for profitable and mature companies. However, that does not mean that EBITDA is the Holy Grail, EBITDA should always be used with other metrics when analysing a company and at least one other metric when valuing a company. 

 

At Front Figure, we use the EV/EBITDA and DCF when valuing a profitable and mature company and the EV/Sales and DCF when valuing a startup.

Do you need to value your company or find out the financial feasibility of your new idea? Check out Front Figure. It is quicker and more cost effective compared to other traditional methods.

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