This post will take a dive into the concept of EBITDA, an important metric in private business valuation and analysis.
The EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This metric can be seen as a proxy for cashflows from a company’s operations and, therefore, used to analyze a company’s operating performance.
The EBITDA metric is a variation of the operating income metric EBIT (earnings before interest and taxes) that excludes non-operating expenses and certain non-cash expenses. The purpose of these deductions is to remove the factors that business owners have discretion over, such as debt financing, capital structure, methods of depreciation, and taxes. Thus, it can be used to showcase a firm’s financial performance without accounting for its capital structure and discretionary decisions by management (in other words, accelerated depreciation).
EBITDA is calculated as follows:
EBITDA = Net Income + Interest Expense + Taxes + Depreciation and Amortization.
EBITDA = Operating Profit + Depreciation and Amortization
In simpler terms, you minus all expenses from the company’s revenue to arrive at net income/net profit, but EBITDA doesn’t go all the way down to net income; it stops before the expenses of interest, taxes, depreciation, and amortization.
- Interest Expense: This is added back to net income, as it depends on the financing structure of a company. The higher the debt in a company’s capital structure, the higher its interest expense. Hence, it is easier to compare the relative performance of companies by adding back interest and ignoring the impact of capital structure on the business. One must also note that interest payments are tax-deductible.
- Taxes: These depend on the region that a company operates in. Also, they are not affected by the financial performance of the company, and therefore are added back to enable the comparison of companies that work in different geographies.
- Depreciation and Amortization: Depreciation expense is based on a portion of the company’s tangible fixed assets deteriorating. Amortization expense is incurred if the asset is intangible. Also, they depend on the historical investments the company has made, and not on the current operating performance of the business. These metrics are influenced by factors such as the useful life of the assets involved, the salvage value, and the method used to depreciate or amortize the assets (often taking advantage of higher depreciation to lower taxes). Therefore, they are excluded from the EBITDA.
The Use of EBITDA in Valuation
The EV/EBITDA multiple (enterprise value/earnings before interest, taxes, depreciation, and amortization multiple) is a commonly used metric in valuation. It helps analysts compare different companies in the same industry, as well as the subject company with its industry to understand if the company in question is undervalued or overvalued.
EBIT vs. EBITDA
EBITDA is used as a proxy for cashflow to analyze and compare the profitability between different companies in the same industry, as it eliminates financing effects and accounting decisions. For a company or an industry that requires relatively low capital expenditures to maintain its operations, the EBITDA may be the metric to use.
However, when one looks at a capital-intensive industry or company, such as mining and infrastructure, EBITDA turns out to be meaningless. This is mainly due to the extensive amount of capital spending required in these industries. Therefore, due to a large depreciation and amortization expense, the EBITDA and the cashflow for the industry or company would be very different. In such a case, the use of EBIT incorporates the significant investment into fixed assets required to generate the operating income of the company.
For example, let’s assume company ABC has the following income statement:
|Less: Operating Expenses||$50|
|Less: Interest Expense||$20|
|Earnings Before Taxes||$90|
|Less: Tax Expense||$40|
(Additional information: depreciation of $20 and amortization expense of $20 included in the operating expenses.)
EBITDA = Net Income + Interest Expense + Taxes + Depreciation and Amortization
EBITDA = $50 + $40 + $20 + $20 + $20
EBITDA = $150