Stock investing comes with risk, so it’s a good idea to research companies before you invest in them. EBITDA is a popular metric that analysts and investors use for determining the current performance of a company. It measures a company’s earnings, excluding certain expenses, to give you an idea of how well a company is handling its operating costs. EBITDA also makes is easier to compare companies across geographies and industries. While many investors choose to leave EBITDA and other tools of stock analysis to their financial advisor, here’s a primer on how it’s calculated and used.
What Is EBITDA?
The term EBITDA stands for “Earnings Before Interest, Tax, Depreciation and Amortization.” Investors and analysts use EBITDA as one way to evaluate a company’s performance and overall profitability. In particular, it gives investors an idea of a company’s cash flow and operating profit. That knowledge helps you understand how well a company can handle its various operating costs.
Other common measures of profitability, such as net income, don’t always tell the whole story of a company’s finances. EBITDA allows you to more easily compare companies across various market sectors, without worrying about some of the intangibles that can skew profit numbers.
Breaking Down Each Component of EBITDA
To further understand EBITDA, let’s look at the individual factors that exist within this acronym. Here’s a breakdown of each:
- Earnings: In this case, earnings is synonymous with net income. You can find a company’s net income number on its income statement.
- Before: This term indicates that we are excluding certain items from the final profit measure. By removing the following values, it means we’re not subtracting them from earnings the way that companies usually do. Because the net income number already subtracted these expenses, we need to add them back in. That means EBITDA is higher than a company’s final reported profit number.
- Interest: This refers to interest that a company must pays on its debts and loans. It’s excluded because the amount of interest a company pays depends on the way it receives its funding. Financing operations through either equity or debt can affect profit numbers and, in turn, slightly misrepresent a company’s worth to investors.
- Tax: This includes taxes at the federal, state and local levels. It’s useful to exclude them because how much a company pays in taxes depends largely on where it does business. Therefore, tax rates are largely out of a company’s control.
- Depreciation: This can make things a bit confusing, as depreciation deals with investments in the form of physical assets. This is because companies often need hardware to offer their services or create their products.
- Amortization: In many cases, the assets a company is amortizing depend on the debt a company has. Because it varies by company and situation, it’s useful to exclude amortization when formulating a useful value of a company.
How to Calculate EBITDA
EBITDA won’t appear on a company’s financial documents, as there are no laws requiring companies to report it. So to start, you will need a company’s income statement, or more specifically, a profit and loss (P&L) statement. At or around the bottom of this, you’ll see a company’s profit or net income. From that value you can work your way up the income statement, adding back the expenses related to taxes, interest, depreciation and amortization.
Depreciation and amortization often appear on a single line. Additionally, companies will sometimes break out the individual assets that lead to these expenses. However, there should be one line that lists the overall expense. You may also see a line with profit before taxes. Starting with this number instead of the final profit can help speed up your calculations.
Here’s the formula you can use to calculate EBITDA on your own:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Example of an EBITDA Calculation
To create a simple example of how to use EBITDA, consider a comparison of two companies. They are mostly identical, except that Company B gets its financing through equity investors and Company A finances its operations through loans.
|Company A vs. Company B|
|Company A||Company B|
|Cost of Goods Sold||$2,000||$2,000|
|Funding from Equity||$0||$10,000|
|Interest Expense ($10,000 in debt at 10% interest)||$1,000||$0|
|Depreciation of Equipment||$1,000||$1,000|
|Income Before Taxes (EBT)||$6,000||$7,000|
|Taxes (21% corporate tax rate)||$1,260||$1,470|
Based on the table above, Company B appears to be the stronger option, as it boasts a higher net income than Company A. That’s because Company A has the additional expense of interest on its debt. Company B doesn’t have to worry about that, as all of its funding comes from the investments of its equity holders.
Let’s calculate each company’s EBITDA to determine which is technically a better investment:
- Company A: $4,740 (net income) + $1,000 (interest) +$1,260 (taxes) + $1,000 (depreciation) + $0 (amortization) = $8,000 in EBITDA
- Company B: $5,530 (net income) + $0 (interest) +$1,470 (taxes) + $1,000 (depreciation) + $0 (amortization) = $8,000 in EBITDA
At the end of the day, both companies have $8,000 in EBITDA, which essentially makes them equal. This is mainly because they each raised money in distinctly different ways. Unlike a traditional, profit-based evaluation, EBITDA makes it easy to see that these companies are more equal than their basic numbers might suggest.
Variations of EBITDA
EBITDA, while common, is particularly useful for companies that are capital-intensive, which are any that require a lot of investment to produce goods or services. This heavy investment can result in taking on large amounts of debt. Depending on how and why you’re analyzing a company, there are a few similar metrics you may consider as well.
EBIT is common, as it’s useful for the evaluation of most companies. It looks at a company’s earnings before interest and tax expenses, as the removal of the “D” and “A” indicates. EBIT measures a company’s operating income and helps you see if the company is making enough to stay in business.
EBT, or “Earnings Before Taxes,” is another frequently used metric. Because taxes are largely out of a company’s control, investors like to use EBT for some comparisons. This is especially true for companies that have to pay different federal or state taxes. When you look at a company’s income statement, you will see a value for profit before taxes.
You may also see EBITA in some cases. It’s often used on an internal basis by companies. In other words, you probably won’t encounter this much as an investor.
EBITDA is an important measurement for investors, financial analysts and financial advisors alike. To reiterate, this acronym stands for “earnings before interest, tax, depreciation and amortization.” The purpose of excluding these expenses is that they can make it difficult to get a true picture of a company’s earnings. That’s also why EBITDA is sometimes more useful than the profit number you find on a company’s standard income statement. For example, a company that funds itself through debt instead of equity will have a lower profit number. That doesn’t necessarily mean it’s worth less, though.
While the way EBITDA is calculated surely has its advantages, not everyone agrees on its merits. More specifically, Warren Buffett is a major critic of EBITDA. This is because it lacks the ability to account for a company naturally losing some value over time due to interest, taxes and depreciation. So although EBITDA is helpful, review its insights with a grain of salt.
Tips for Becoming a Better Investor
- Talk with an financial advisor. If you haven’t done much investing before, it can be especially useful to consult with a financial advisor. They can sit down with you and look at your whole financial situation to help you make investment decisions. Use SmartAsset’s advisor matching tool to find suitable options in your area. If you’re ready to find an advisor, get started now.
- Build a balanced portfolio. Your specific investing goals will determine how you invest your money. For example, someone who has already retired probably wants to invest more conservatively than someone who is 30 years away from retirement. However, experts generally recommend that you minimize risk by creating a balanced and diversified portfolio. Starting with an asset allocation calculator can help you plan your portfolio according to your personal preferences.
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