What is Ebitda, and does it matter to investors?

Ebitda is a widely-used metric to assess the strength and profitability of a business. It helps investors understand the operational strength of a company. It helps investors, lenders, and analysts understand the operational performance of a company, focusing on its ability to generate earnings from its core business activities. However, this measure has its limitations and works best when used alongside other financial indicators to gain a broader understanding of a company’s overall health.

Ebitda stands for Earnings Before Interest, Tax, Depreciation and Amortisation. It is calculated in two ways. The first takes net income and adds interest, tax, depreciation and amortisation costs back in.

The second formula uses operating income and adds back depreciation and amortisation.

The two formulas should give approximately the same result.

Core business performance

The purpose of Ebitda is to shine a light on a company’s underlying business performance. It looks beyond elements such as tax environments—which are not fully under a company’s control—and accounting rules on asset depreciation, which do not directly relate to the day-to-day running of the business.

Ebitda can be particularly useful when comparing companies in different countries because it neutralises the impact of different tax rates or accounting standards. It is also often viewed as a proxy for cash flow because it shows what is left of a company’s earnings after expenses. Ebitda will usually be cited in a company’s accounts as part of its standard reporting, though it is not an official accounting metric.

Ebitda is often viewed as a proxy for cash flow because it shows what is left of a company’s earnings after expenses.

Nevertheless, investors and analysts use it to assess a company’s financial health. Banks may use it when making lending decisions, because it provides an indication of a company’s ability to service its debt. It may also be used by investment banks or private equity groups involved in corporate activity involving a company, such as a buyout or other form of acquisition. Business owners and management teams may use it as shorthand when valuing their business.

A good level of Ebitda is usually considered to be at least twice the company’s interest expenses. This suggests a company has plenty of cash flow to pay its debt interest. However, the level varies according to the industry – some sectors are more capital-intensive than others – as well as by company size or growth stage. For instance, capital-intensive industries, like manufacturing or energy, might have different EBITDA expectations compared to service-based businesses.

Ebitda and enterprise value

Ebitda is most commonly used in conjunction with a company’s enterprise value, a measure of a company’s value that takes into account market capitalisation, debt and cash reserves and is considered a more sophisticated measure than market capitalisation alone. The ratio between enterprise value and Ebitda is generally considered to offer a more nuanced insight into a company’s value than the more popular price-to-earnings ratio, because it accounts for a company’s debt and cash position and provides a clearer picture of operational strength.

In general, a ratio below 10 is considered undervalued, although here too the level depends on the sector and geographical location. Technology companies tend to trade at high EV/Ebitda ratios, while energy companies trade significantly lower. As a result, the measure is most meaningful when used to evaluate similar companies within the same industry.

Ebitda has been subject to considerable criticism, most notably from Warren Buffett, who argues that factors such as depreciation and interest are real costs for a business and should not simply be ignored. At the 2017 Berkshire Hathaway shareholders’ meeting he described Ebitda as “a very misleading statistic [that] can be used in pernicious ways”.

Asset costs

One key limitation is that by excluding depreciation and amortisation, Ebitda can overlook the ongoing costs involved in maintaining or replacing assets. For businesses that own lots of physical equipment or property, this is a real concern. Ignoring these expenses might overstate a company’s true profitability.

Its critics also say that it should not be used to represent cash earnings. Free cash flow is calculated in different ways, but it almost always includes capital expenditure. Says Buffett: “Does management think the tooth fairy pays for capital expenditures?” Ebitda assumes that profitability is generated by sales and operations alone. Ebitda also excludes changes in working capital, which might otherwise indicate financial problems.

Ebitda also ignores interest costs. If a company has a high level of debt, this cost may be significant and can leave it vulnerable to shifts in interest rates. High debt is often a contributing factor in business failure, and as a result Ebitda may present a misleading picture of the potential risks to the business.

Ebitda gives no hint that a company’s balance sheet strength may be deteriorating.

It can also be manipulated. Companies that have borrowed heavily or are experiencing significant capital expenditure costs may start to quote Ebitda more prominently to divert attention from their problems. Ebitda gives no hint that a company’s balance sheet strength may be deteriorating.

High-growth companies

While focusing on operational costs can give a ‘purer’ view of a company, in reality no business exists in a vacuum, and all have financial obligations that are important to their sustainability.

For fast-growing companies, Ebitda can also be less informative. Early-stage businesses may report negative Ebitda, meaning they are not yet profitable at the operational level. However, a company in rapid growth mode could have the same Ebitda figure as one in financial difficulty. This shows the importance of context when interpreting the number.

In summary, while Ebitda can be a helpful measure of a company’s core operating strength, it is not the only number that matters. Investors also look at a business’s debt levels, capital spending needs, cash flow, and prospects for future growth. Ebitda can sometimes make a company’s profitability look better than it really is and might not fully reflect the risks involved. Still, when used thoughtfully and alongside other financial metrics, Ebitda can help investors identify companies worth a closer look.