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Will Ryder, Equity Analyst, takes a closer look at this controversial accounting metric.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
You may have come across the term “EBITDA” when reading company reports or investing articles. It’s an acronym for Earnings Before Interest, Taxes, Depreciation and Amortisation.
As the name suggested EBITDA is calculated by adding four items back to total profits (or earnings). It’s used as a rough and ready measure of the cash a business generates; cash that can be invested in the business, used to pay debts or returned to shareholders.
Let’s start with the “DA”.
Depreciation and Amortisation represent the wear and tear on a company’s assets.
An example may help. Imagine you open a printing business and spend £10,000 on your printing press. Each year, after paying for ink, staff costs and taxes etc., you have £1,000 left over. After 10 years the printing press breaks and becomes worthless scrap.
Did you make a profit?
No, because you spent £10,000 on the press at the start, and then earned £1,000 a year for 10 years. You ended up with exactly what you started with: £10,000.
Accountants deal with this issue by spreading the cost of the printing press over its useful life. This shows up as Depreciation in company accounts each year but, crucially, all the cash was spent in previous years. Depreciation is therefore described as a non-cash charge.
While Depreciation relates to physical assets like printing presses, Amortisation relates to intangible assets like brand names or patents. It works in exactly the same way – with upfront cash costs spread across an assets working life.
We add depreciation and amortisation back in EBITDA because we want to see how much cash is available to management to invest going forward.
Now for “IT”.
Unlike Depreciation and Amortisation, the Interest payments companies make on their debt are real, cash costs. We add them back because, in theory, management can choose how much debt the company should hold.
Companies pay Taxes on profits – and remember we’re interested in cash here, not necessarily profits. Moreover interest payments are tax deductible. Since management can decide how much debt a company holds, they can also influence how much Tax the company pays.
To simplify things we just add both Interest and Tax back for EBITDA – remember we said it was rough and ready!
Unfortunately EBITDA can be problematic. We’ll let investment legend and Berkshire Hathaway CEO Warren Buffett explain:
“Any management that doesn’t regard depreciation as an expense is living in a dream world… 'I’ll look at that [EBITDA] figure when you tell me you’ll make all of the future capital expenditures for me.' ”
This is the biggest problem with EBITDA. Equipment wears out and must be repaired or replaced, and these costs can’t be ignored. Management can decide which investments and repairs to make, but it must make some.
The other potential pitfall is “Adjusted EBITDA”.
Because EBITDA is not an official accounting metric companies can make adjustments to it. Usually this is done in good faith to give investors a better picture of the business, but that’s not always the case.
Adjusted EBITDAs can get very silly. WeWork’s infamous “community adjusted EBITDA” excluded a whole range of normal running costs like marketing expenses. Investors widely considered it to be a nonsense.
EBITDA is a quick, if imprecise, measure of the cash that’s available to management each year. It’s commonly used when thinking about how well a company can service its debts – because debt holders will always demand their pound of flesh before taxes or reinvestment.
On the other hand, it doesn’t include some pretty important running costs, and if all your cash is tied up servicing debt that’s not good news for shareholders.
Investors should be careful with EBITDA and similar alphabet accounting metrics, particularly for capital intensive businesses with large depreciation costs or interest payments. In our view EBITDA works best as a rough measure of cash flow for relatively capital light businesses.
In a future article we’ll show how EBITDA can be combined with a company’s Enterprise Value to form EV/EBITDA. It’s a type of valuation that takes into account a company’s debt as well as its shares, and can work alongside a PE Ratio.
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