Friday, 18 March 2016

What is EBITDA?

Financial professionals are sometimes guilty of throwing around jargon without stopping to realize that most (normal) people might not know what they are talking about. EBITDA is one of those terms. Although it is fairly easy to define, there is some nuance to it. This blog post will attempt to shed some light on the financial term "EBITDA" and highlight why it is important.

What does E.B.I.T.D.A. stand for?

Earnings Before Interest, Taxes, Depreciation and Amortization.

EBITDA is an important financial measure of a business's profitability but you won't find it in an accountant's financial statement. The reason for this is that EBITDA is more of finance term than it is an accounting term. It is the profit that a business makes before any interest on debt, taxes or depreciation and amortization. It must be calculated separately from the information that is presented on your accountant-prepared financial statement.

So why go to the trouble of calculating EBITDA? Why not just use net income as reported on the financial statement?

There are a few reasons why you might want to calculate EBITDA versus relying on net income. The first reason is comparability. If you were analyzing several companies in an industry for their efficiency, profitability or relative valuation, net income would distort your analysis. The reason for this is that 2 similar companies with the same revenue and profit margins can report very different net income amounts. The reasons are that one company might be financed by a lot of debt and the other company might be financed by equity. The company that has debt would have interest payments that
they would expense which would reduce its net income. Also, tax rates might differ in different parts of the country which could distort an analysis. Also, if you are analyzing the results over the past several years, if tax rates changed then the net income would fluctuate too. And with respect to depreciation and amortization, companies can have differing policies with respect to depreciation that would flow through to the net income. The point to all of this is that net income is not necessarily the best number to use for analysis. EBITDA is a much more 'pure' number for analysis and comparison purposes.

EBITDA is attractive to use in an analysis because it represents the amount of profit (before taxes) that would be available to the capital holders of the company. In other words, it doesn't matter if the company is financed by 100% debt or 100% equity, the amount available for capital (equity or debt) would be the same.

In the financial press you might have heard that a company sold for 10x EBITDA or 8.5x EBITDA. It is very rare to hear that a company was sold for 10x net income. Using the EBITDA number is a better comparison and lends itself to rules of thumb, like “companies in X industry usually sell for 6x EBITDA.” However, relying on rules of thumb is not advised as there are many deficiencies but many people (unfortunately) do, and EBITDA multiples are a common rule of thumb that is cited.
It is also worth mentioning that when “valuing” a company based on a multiple of EBITDA, the result is the sum of the invested capital (total value of debt + equity) and NOT only the equity. As a simple analogy, think of a business as a house that is appraised at $1 million and has a $700,000 mortgage on it. The equity in the house would be $300,000. An EBITDA multiple, if correctly applied, would measure the total value of the “house” of $1 million and not merely the equity component of $300,000. This is an often misunderstood notion that could be very costly if the analysis is not done properly.

There are some issues with relying on EBITDA

EBITDA is a good number to use in an analysis of a business but it certainly is not perfect. Used as a 'measuring stick' it could be helpful but it does ignore some important elements of a business. A few examples - if a company was deficient in its working capital needs, it would not be reflected in the EBITDA number.  Also, if a company has significant ongoing capital expenditure requirements, then that would also not be reflected in the EBITDA. Also, the reality is that different companies can, in fact, have different tax rates that apply to them which absolutely would impact the value of the company. Also important to note that EBITDA that is based on reported results is backward looking, while a business valuation exercise cares more about the future than it does about the past.

There is also the risk of relying on 'quick & dirty' valuations using simple EBITDA multiples to value a company. For instance, if a person 'hears' that companies in their industry sell for 5x EBITDA then they could simply calculate their EBITDA, multiply it by 5x then they would have their valuation done in 5 minutes. There are many, many problem with doing this. It brings to mind the programming term, GIGO (garbage in, garbage out). A proper valuation might look at implied EBITDA multiples as a secondary test of valuation reasonableness but used as a primary business valuation technique would not be advised.

Steve Skrlac, MBA, CFA, CBV
Keystone Business Valuations
Located in Burlington, Ontario and serving southern Ontario.

This blog post does not offer or replace professional advice.

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