Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
What is EBITDA?
EBITDA is a widely used number right across finance – valuation and leverage analysis are just a few examples. EBITDA is a measure of profitability without taking the sometimes arbitrary cost of tangible (depreciation) and intangible assets (amortization) into account. EBITDA is often seen as a proxy for cash flow but one has to remember that EBITDA is before tax, operating working capital, and CAPEX, so even in the least asset-intensive business it still would not be a complete proxy for cash.
Companies are often valued based on Enterprise Value multiples which require an earnings number before finance costs. One could consider using EBIT (cleaned operating profit), but there are two problems.
First, and less importantly, companies have different accounting policies for amortization and depreciation. So, while one company might depreciate an asset over 10 years, another may choose 15 years and have a corresponding lower depreciation expense.
Second, and far more importantly, companies must revalue assets in acquisitions, even if the assets were developed internally. A company that has made acquisitions will have recorded more PP&E and intangibles on its balance sheet than companies that grow organically.
So, if we are comparing companies, then EBIT will penalize acquisitive companies unfairly. Even EBITA has issues as it won’t strip out additional depreciation from net PP&E step-ups. EBITDA is used to strip out the impact of these differences when comparing two companies.
You must be more careful when using it as an absolute metric as it is not a cash and does not incorporate the very real cost of fixed assets. There are different situations for which EBITDA is calculated and they will drive what is included and excluded in the calculation.
Key Learning Points
- Earnings Before Interest, Taxes, Depreciation, and Amortization or EBITDA represents the recurring cleaned operating profit of a company before the impact of depreciation and amortization expenses for a period
- It is not a proxy for cash flow as even the least asset-intensive industries cash flows would not equal its EBITDA
- Depreciation and amortization are non-cash expenses and represent the use of long term assets
- Corporations usually disclose their own calculation of EBITDA in their earnings press release, or 8-K document if they are a publicly-traded company
- For valuation purposes, stock-based compensation should generally not be adjusted in the calculation of EBITDA
- EBITDA is used in credit analysis as a rough estimate of debt capacity
EBITDA Use in Valuation and Investment Banking
EBITDA is used in relative valuation in the calculation of enterprise value multiples, in other words, where you are comparing companies in the same industry. Be careful with asset-intensive industries where capex is a key value driver, in these cases we often calculate EBITDA – capex. EBITDA is calculated as follows:
|+/- Non-recurring items|
Ensure you clean operating profit of non-recurring items and then add back depreciation and amortization. Non-recurring items are for instance impairments, large restructuring and litigation. If you take depreciation and amortization from the cash flow statement, be careful there are no impairments embedded, as you might have already adjusted for these in the non-recurring items.
The cash flow statement usually starts with net income, which means that the depreciation and amortization number includes ALL depreciation and amortization, so if the company has discontinued operations, the amortization and depreciation number will include amortization and depreciation from the discontinued items.
Corporations usually disclose their own calculation of EBITDA in their earnings press release, or 8-K document, if they are a publicly-traded company. You can start with these numbers but DO be careful. Here’s an example from IAC Inc’s letter to shareholders:
Note the above extract includes an adjustment for stock-based compensation which would not be an appropriate adjustment for valuation purposes.
In the EBITDA example above, IAC breaks down the adjustments to operating income to calculate ‘adjusted EBITDA’. They add back depreciation, amortization, and contingent consideration fair value adjustments – all OK. However, they ALSO add back stock-based compensation. This is not OK. Stock-based compensation is a real cost to shareholders and should not be adjusted for valuation purposes. Credit analysts often add back stock-based compensation as it is non-cash, and in the short-term doesn’t hamper the ability of the firm to service debt. So, credit EBITDA can be different from valuation EBITDA.
For IAC you should deduct the stock-based compensation from their adjusted EBITDA number to get an EBITDA for valuation purposes:
Associate/Equity Method Income
Another issue is controlled versus consolidated EBITDA. In other words, should you include associate/equity income in EBITDA and should you embed associate investments/equity method investments in Enterprise Value?
In most cases EBITDA will be calculated on a controlled basis, i.e. associate/affiliate income will not be included. The calculation of enterprise value will need to ensure that the market value of affiliates/equity method investments has been deducted in the bridge from equity to enterprise value as the share price of the company includes the value of the investment. This will ensure a consistent multiple. Investments accounted for under the equity method will then be valued separately.
EBITDA Use in Credit
The credit markets use EBITDA as a rough estimate of debt capacity. Although it is dangerous to consider EBITDA as a ‘proxy for cash flow’, it is widely used. Remember, EBITDA is before taxes, investment in working capital, and capital expenditure. Credit analysts usually use historic earnings when calculating their ratios for a company’s existing debt / EBITDA ratio, and most commonly Last Twelve Months or ‘LTM’ EBITDA.
Credit analysts often use a bottom up approach to calculate EBITDA (from net income upwards), rather than cleaned operating profit plus depreciation and amortization which is more common in investment banking. The bottom up approach might be because credit does not necessarily care whether income is core or non core, as long as the income is sustainable and can help generate cash flow to service debt.
Standard and Poor’s definition of EBITDA is as follows:
Problems Comparing LTM EBITDA Across Sectors
Using Debt to LTM EBITDA as a leverage ratio is dangerous when comparing companies with very different cash conversion profiles. Take the example of a subscription company where customers pay upfront compared to a manufacturing business:
The media business converts $1 of EBITDA into 61.7 cents in free cash flow, compared to the manufacturer which converts $1 of EBITDA into just 40.6 cents in free cash flow.