What is EBITDA? Calculation and Significance in Stock Investing

Evaluating a company’s health is essential to any stock investor. There are different ways of conducting such an evaluation, a popular one being EBITDA. But what is it? How do you calculate it? And, what’s its significance?

If you’ve been asking yourself any of these questions, this article is for you. It is a deep dive into the metric, explaining its workings and much more.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Think of it as a stripped-down version of a company’s profit. It removes accounting complexities that can blur the accurate picture of how well a business generates cash.

Why does it matter? Because it cuts through the noise to show how efficient a company is at turning revenue into profit. It’s like a company’s core operating muscle, unburdened by financing choices, tax rates, or depreciation.

This metric lets you compare companies across industries, even those with different capital structures or tax situations. It’s like a universal translator for profitability, making it easier to spot strong performers.

How to Calculate EBITDA, Formulae and Calculations

There are two ways to calculate this metric. The first uses the firm’s net income, while the other uses its operating income. Both methods will give you the same result as long as you have the correct information from the company’s financial statements. Here are the formulas for each method:

• EBITDA = Net Income + Taxes + Interest Expense + Depreciation and Amortization

Or

• EBITDA = Operating Income + Depreciation and Amortization

Let’s break down each component of the formula:

• Net income is the profit or loss a company earns after deducting all expenses.
• Taxes are the levies a company pays to the government.
• Interest expense is the cost of borrowing money to finance the company’s operations
• Depreciation and amortization are the non-cash expenses that reduce the value of the company’s assets over time.
• Operating income is a company’s profit from its core business activities before deducting taxes and interest. 

EBITDA Examples

To illustrate how to calculate EBITDA, let’s look at examples of different companies and industries.

Company A  is a software company with a net income of $50 million, pays $10 million in taxes, has no interest expense, and has $20 million in depreciation and amortization. Using the net income method, we can calculate its EBITDA as follows:

EBITDA = Net Income + Taxes + Interest Expense +Depreciation and Amortization

= 50 + 10 + 0 + 20

= $80 million

Company B is a manufacturing company with an operating income of $100 million, pays $20 million in interest expense, and has $30 million in depreciation and amortization. Using the operating income method, we can calculate its EBITDA as follows:

EBITDA = Operating Income + Depreciation and Amortization

= 100 + 30

= $130 million

What’s the rationale behind the Metric and use cases?

EBITDA can help investors and analysts compare the performance and valuation of different companies. It acts as a financial compass guiding investors and businesses to better understand operational profitability. This way, it facilitates informed decision-making in various financial scenarios.

Some of its use cases are:

• Calculating the enterprise value (EV) of a company, which is the market value of its equity and debt, minus its cash and cash equivalents. EV/EBITDA is a common valuation multiple that indicates how many times the company’s EBITDA is worth its EV.
• Assessing the company’s financial health and growth potential by looking at its EBITDA margin, which is the ratio of EBITDA to revenue. A higher EBITDA margin means the company has lower operating expenses and higher cash flow relative to its sales.
• To estimate the debt service coverage ratio (DSCR) of a company, which is the ratio of its EBITDA to its debt payments. A higher DSCR means the company has more cash flow available to pay off its debt obligations and interest expenses. This is an important consideration for lenders.
• Compares Profit Across Companies – By removing variable factors like capital structure and tax rates, EBITDA allows more meaningful comparisons across different companies – even if they have different debt levels or operating in different tax jurisdictions.

What are its benefits and limitations?

EBITDA is a useful metric for investors and analysts for several reasons. But it also has its downsides. Here we look at both starting with the upsides.

Benefits:

• It focuses on core operations – EBITDA strips away non-operating expenses, providing a clearer picture of a company’s underlying profitability. This is especially useful for comparing companies within the same industry, even with different financing structures or tax situations.
• Standardized comparison – removing the impact of individual accounting choices, EBITDA allows for a more standardized comparison between companies. That’s valuable for investors and analysts evaluating potential investments across different sectors.
• Valuation tool – EBITDA indicates a company’s cash-generating ability before financial decisions affect it. Thus it helps assess the intrinsic value of a business.
• Financial distress indicator – A declining EBITDA over time can indicate potential financial distress, suggesting a weakening ability to generate profits from core operations. This can be an early warning sign for investors and creditors.

Limitations:

• Ignores key financial aspect – the measure excludes crucial costs like debt servicing, taxes, and asset replacement. This can paint an unrealistic picture of a company’s overall financial health.
• Susceptible to manipulation – there’s no universally accepted standard for calculating EBITDA. Some companies may adjust certain items to inflate the metric. This can be misleading and harm investors.
• Limited cash flow reflection – suggests cash-generating ability; it doesn’t directly reflect actual cash flow. Companies might have strong EBITDA but weak cash flow, raising concerns about their long-term sustainability.
• Oversimplification of financial performance – Relying solely on EBITDA can create an overly simplistic picture of a company’s financial health. It’s crucial to consider it alongside other financial metrics and qualitative factors.

How to calculate and Interpret it Step by Step

To interpret EBITDA, you need to understand its components, formula, and use cases. Here are some steps to follow:

• Identify a company’s net income, taxes, interest expense, depreciation, and amortization of the company from its financial statements. Alternatively, you can use the operating income and depreciation and amortization.
• Calculate the EBITDA using one of the formulae above
• Compare the measure with the revenue of the company to get the EBITDA margin, which is the ratio of EBITDA to revenue. This margin shows how much of the revenue remains as operating cash flow after deducting the operating expenses. A higher EBITDA margin means the company has lower operating costs and higher cash flow relative to its sales.
• Compare the EBITDA with the enterprise value (EV) of the company to get the EV/EBITDA multiple, which is a valuation metric that indicates how many times the company’s EBITDA is worth its EV. A lower ratio means the company is undervalued or has higher growth potential.
• Analyze the trends and drivers of the EBITDA over time and across different segments or regions of the company. Look for the factors that affect the metric, such as sales growth, pricing, cost efficiency, product mix, competition, regulation, and innovation. 

How do you know if your EBITDA is good?

First, compare it to past company performance. Look at EBITDA margins over time to see if there is growth, which indicates improving profitability. Comparing QoQ or YoY gives a historical baseline.

Secondly, compare it to competitors & industry averages. Research similar public companies or industry benchmarks to contextualize your figures. This gives a sense of relative performance.

Additionally, compare it to your revenue. Consider EBITDA a percentage of total revenue to see profit generation ability. Higher than 20% is generally solid. Over 30% is considered very good for most non-software companies.

Ask yourself if it meets lender/investor requirements. Does the metric need to reach certain levels for lending agreements or to attract investors? Use those pre-established goals as a barometer. 

Finally, focus less on the absolute figure and more on the trajectory. Rapid EBITDA growth suggests an increasingly profitable business with momentum.

Why use EBITDA instead of net income?

Both EBITDA and net income offer insights into a company’s financial health. However, there are certain situations where using the former as a primary metric might be more advantageous. Here are some key reasons why:

• It removes impact of financing and accounting decisions – it focuses on the business’ operating profitability before taking into account expenses. So, it gives a sense of raw cash flow strength.
• Comparability – Net income metrics can vary considerably from company-to-company because of different capital structures or tax jurisdictions. EBITDA provides a uniform view.
• Removes distortion of non-cash expenses – Depreciation and amortization are accounting expenses that don’t actually represent a cash outlay in the current period. So EBITDA can provide a clearer view.
• Assesses operating efficiency – this metric focuses purely on a company’s operating costs vs revenue generation. This helps investors see the underlying operating efficiency.

What is EBITDA, EBT, EBITDAX and EBIT?

As explained earlier, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It measures a company’s overall financial performance and is often used to analyze and compare company profitability. 

EBT, on the other hand, stands for Earnings Before Taxes. It measures a company’s net income before accounting for taxes. You calculate it by taking revenues and subtracting operating expenses, depreciation, amortization, and interest expenses (but not taxes).

Meanwhile, EBITDAX stands for Earnings Before Interest, Taxes, Depreciation, Amortization, and Exploration Expenses. It’s a variation on EBITDA that companies in certain industries like oil and mining use to evaluate their profitability. The “X” represents exploration costs.  

Finally, EBIT (operating income) stands for Earnings Before Interest and Taxes. It measures a company’s overall operational profitability before considering non-operating and non-cash expenses. You calculate it by taking revenues and subtracting only operating expenses. 

What is adjusted EBITDA?

As the name implies, adjusted EBITDA is a modified version of the standard metric. It takes the standard EBITDA and adds or subtracts certain items to create a more accurate picture of a company’s profitability.

Here’s how it works:

• Starts with the company’s net income.
• Adds back interest expense, taxes, depreciation, and amortization.

• Add one-time, non-recurring, or unusual items that distort the standard EBITDA. Examples include restructuring charges, gain or loss on asset sales, and stock-based compensation expense
• Subtract items that don’t reflect core operating profitability. Examples include synergies from mergers or acquisitions, non-operating income or expenses, and owners’ compensation above market rate.

Benefits:

• Improved comparability – allows for a more apples-to-apples comparison of companies within or across different industries.
• Focuses on core operations – helps isolate the operating performance of a business from financing decisions, tax structures, and non-operating activities.
• Useful for valuation – it provides a more accurate picture of the company’s earnings potential.

Limitations:

• Subjectivity – adjustments made can be subjective, making comparisons less reliable.
• Potential for manipulation – companies can “massage” adjusted EBITDA to make their financial performance look better.
• Not a substitute for other metrics – should be used alongside other financial metrics to get a complete picture of a company’s financial health

FAQ

Is EBITDA the same as gross profit?

No, EBITDA and gross profit are not the same, though they both measure a company’s profitability. Gross profit is a company’s net revenue minus the direct costs associated with producing its goods and services. It does not include operating expenses like research, marketing, or administrative costs.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It measures the overall operating profitability of a company after subtracting all operating expenses, but before accounting for interest, taxes, depreciation and amortization.

Is a 20% EBITDA good?

There’s no one-size-fits-all universal “good EBITDA margin” since it can vary greatly by industry and business model. Whether a 20% EBITDA is good or not depends on several factors, including:

• Industry average – for example, a 20% margin might be excellent for a retail business but average for a software company.
• Company growth stage – 20% margin for a young company could be promising, while for a mature company it might be concerning.
• Trends – its good to analyze the company’s historical EBITDA margins to determine if  20% is a consistent figure, a decline, or an improvement?
• Financial health: Consider the company’s overall financial health beyond just EBITDA. Look at debt levels, operating cash flow, and profitability metrics like net income.

That said

• An EBITDA margin of 10% or more is generally considered good. So, 20% falls within a positive range.
• The S&P 500 average EBITDA margin is between 11% and 14%. So, 20% is even higher than the average for large, established companies.

What’s amortization?

Amortization is the process of expensing the cost of an intangible asset over a specific period of time. Some common intangible assets that are amortized include:

• Patents
• Copyrights 
• Software goods
• Trademarks
• Intellectual property

What is adjusted EBITDA?

Adjusted EBITDA is a modified version of EBITDA that excludes or adds back certain non-recurring, irregular, or one-time gains or expenses. Some examples could include:

• Restructuring costs
• Impairment charges  
• Stock-based compensation
• Acquisition-related expenses
• Foreign exchange gains/losses

What’s a better measure than EBITDA?

There is no definitive answer to what is a better measure than EBITDA. Different metrics have their advantages and disadvantages depending on the context and purpose of the analysis. However, some possible alternatives to are:

• EBIT – Earnings before interest and taxes. This is similar to EBITDA, but it deducts depreciation and amortization.
• Operating Cash Flow – The amount of cash generated by the company’s core business activities. This is calculated by adding non-cash charges back to net income and including the changes in working capital.
• Free Cash Flow – The amount of cash available to the company after paying for its operating expenses and capital expenditures. It is calculated by subtracting capital expenditures from operating cash flow.
• Return On Invested Capital (ROIC) – analyzes a company’s profitability relative to the amount of capital invested, showing how efficient a business is allocating capital into value.

Is EBITDA the same as bottom-line?

No, this metric is not the same as the bottom line. While both financial metrics assess profitability, they differ significantly. The former stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It is a measure of a company’s overall operating profitability.

Conversely, the bottom-line refers to the net income or net profit, a company’s final earnings, after subtracting all expenses. These include operating expenses, taxes, interest, depreciation and amortization.

What’s the difference between depreciation and amortization?

Depreciation covers tangible assets, like buildings, equipment, and vehicles. These experience physical wear and tear over time, decreasing their value. Amortization, however, covers intangible assets, like patents, copyrights, and trademarks. These lack a physical form but can lose value due to different factors like legal expiration.

Depreciation uses various calculation methods like straight-line, accelerated, or units-of-production. It also considers the asset’s salvage value. Meanwhile, amortization often uses the straight-line method and ignores the salvage value.

Both reduce the carrying value of the assets they cover on the balance sheet and are expenses on the income statement. Depreciation lowers reported profits over time, reflecting the gradual decrease in the asset’s value. In amortization, however, the expense may not directly correspond to a physical deterioration.