What is EBITDA?

EBITDA stands for "Earnings Before Interest, Taxes, Depreciation, and Amortization." It is a financial metric used to evaluate the operating performance of a company. EBITDA provides a measure of a company’s profitability by excluding certain non-operational expenses that can vary between different businesses or be influenced by accounting practices.

How is EBITDA calculated?

Take your net income

[+] Interest Expenses

[-] Interest Income

[+] Taxes

[+] Depreciation & Amortization

Why is EBITDA used?

• Performance Evaluation: EBITDA provides a measure of a company’s operating performance and profitability, allowing investors to access the ability of a company to generate earnings from its core operations. By excluding non-operational expenses, EBITDA provides a clearer picture of a company’s operational efficiency and performance.
• Comparability: EBITDA allows for the comparison of companies operating in the same industry irrespective of their capital structures, debt levels, or accounting methods. It provides a standardized metric that eliminates the effects of interest expenses, taxes, depreciation, and amortization, which can vary significantly between different companies.
• Cash Flow Analysis: EBITDA is often considered a proxy for cash flow generation. It excludes non-cash expenses like depreciation and amortization, it provides insights into a company’s cash-generating potential.
• Business Valuation: EBITDA is commonly used in business valuation methods, such as the EBITDA multiple or EBITDA-based valuation models. EBITDA can provide a basis for determining a company’s value in mergers and acquisitions, investment analyses, or other valuation exercises.
• Debt Analysis: EBITDA is also utilized in assessing a company’s ability to service its debt obligations. Lenders and creditors often use the debt-to-EBITDA ratio. This ratio helps evaluate a company’s capacity to generate sufficient earnings to cover interest expenses and repay debt.
• Reference in ratios: EBITDA acts as a reference for a number of ratios.

EBITDA is not equal to cash flows

• Cash flow measures the actual inflows and outflows of cash in a business reflecting the movement of money into and out of the company. On the other hand, EBITDA is a profitability measure that represents a company’s earnings from its core operations.
• Cash flow provides a comprehensive view of a company’s liquidity and ability to meet its financial obligations. EBITDA, on the other hand, focuses specifically on the operating performance of a company and excludes interest, taxes, depreciation, and amortization.
• Cash flow reflects the actual timing of cash inflows and outflows. It captures the real-world cash movements. EBITDA, however, does not consider the timing of cash flows. It focuses solely on the profitability of a company’s operations.

Problems with EBITDA

• One criticism of EBITDA is that it disregards the cost of debt by excluding interest and taxes from earnings. This approach can potentially obscure poor financial decisions and weaknesses in a company’s financial structure.
• Relying solely on EBITDA may hinder a company’s ability to secure loans as lenders typically consider a company’s actual financial performance in their loan calculations.
• EBITDA overlooks the depreciation and obsolescence of assets, as well as the expiration of copyrights and patents, thereby neglecting these costs.
• EBITDA ignores or hides high-interest financial burdens.
• EBITDA does not fall under GAAP guidelines and is a measure computed by companies at their own discretion. Therefore, without accounting regulations, companies can indulge in unfair practices and skew their EBITDA to exude a positive image to investors.

EBITDA helps in the calculation of EV/EBITDA

EV/EBITDA is a commonly used financial metric in valuation and investment analysis.

EV: Enterprise value, the actual value of a business is termed as enterprise value. It looks at the entire market value rather than just the equity value.

This ratio determines the pricing, a company can get in a particular industry depending upon its operational profitability.

Advantages Of Using EBITDA Multiples For Valuation

• EBITDA multiples are commonly used for valuation due to their simplicity in calculation using financial statements.
• It provides a faster and simpler method for determining value compared to conducting cost or income analyses.

Disadvantages Of Using EBITDA Multiples For Valuation

• EBITDA lacks an official accounting definition, making it susceptible to misrepresentation and posing a significant risk of approximation errors.
• EBITDA alone does not provide a direct valuation for the business; it serves as an estimation tool by allowing comparisons to peer companies’ metrics.
• EBITDA multiples for peer companies can be imprecise due to potential significant differences between the subject company and its peers.

Why EBITDA multiple of one industry is different from another?

• Expected growth.
• Profitability margin
• Risk factor
• Current market conditions
• Specific market shocks
• Capital expenditure in the industry and the company.
• Performing period of industry
• Change in strategy or business model.

Industries using EBITDA multiple with their standard multiples for the year 2023.

Source: Aswath Damodaran

Why some industries don’t use EBITDA multiple:

1. Capital-Intensive Industries: Industries that require significant capital investments, such as manufacturing, construction, or utilities, may prioritize other metrics over EBITDA multiples. These industries often have substantial depreciation and amortization expenses, which can significantly affect EBITDA.
2. Technology and Start-up Companies: Start-up companies, revenue growth and potential future earnings are often more important than current profitability measures. Start-ups may prioritize metrics like user base, market share, or revenue growth rate as they aim to capture market opportunities and establish themselves. As a result, traditional profitability measures like EBITDA may be less significant in their valuation and investment analyses.
3. Service-Based Industries: Industries that primarily provide services, such as consulting, legal, or advertising, may place less emphasis on EBITDA multiples. Since these industries often have lower capital expenditures and less reliance on tangible assets, metrics like revenue growth, client retention rates, or billable hours may be more relevant in evaluating their performance and valuation.
4. Intellectual Property and Licensing Industries: Industries that derive a significant portion of their value from intellectual property, patents, or licensing agreements, such as software, entertainment, or pharmaceuticals, may focus on metrics that reflect the uniqueness and market potential of their intellectual assets. Valuation methods like DCF analysis or royalty-based approaches may be more appropriate in these cases.
5. Government and Non-profit Sectors: EBITDA multiples are less commonly used in the government and non-profit sectors, as their primary focus is typically not on profitability or market valuation. These sectors often prioritize metrics that reflect social impact, program effectiveness, or financial sustainability within their specific contexts.
6. Research and Development-Intensive Industries: Industries that heavily invest in research and development (R&D), such as pharmaceuticals, biotechnology, or technology, may prioritize metrics that reflect innovation, intellectual property, and future earnings potential.
7. Distressed or Turnaround Situations: In industries facing financial distress or undergoing turnaround efforts, EBITDA multiples may not accurately reflect the potential value of the company. In such cases, valuation methods that consider asset values, restructuring plans, or discounted cash flow projections may be more appropriate to determine the company’s intrinsic worth.