INVESTING EXPLAINED: What you need to know about Ebitda, and why you should take it with a pinch of salt
Eh? A bit of what?
Ebitda is a frequently-used acronym standing for Earnings Before Interest Tax Depreciation and Amortisation.
It is a measure of a company’s profit or earnings before taking off a list of deductions: interest on its debts, tax, the depreciation over time of its fixed assets like buildings, plant and machinery and the amortisation of its intangible assets. That is the decrease in the value of brands, patents and trademarks, also over a set time.
Writing on the wall: Ebitda provides a snapshot of a company’s performance
What does it tell us?
Ebitda provides a snapshot of a company’s performance, including its cash flow, eliminating factors over which the business has little or no control like accounting policies and taxation.
As a result it is a means of assessing the merits of similar companies in the same industry, although if you are thinking of buying shares, it is not an entirely reliable guide on its own.
How else can it be used?
Many analysts favour the net debt-to-ebitda ratio because it provides an indication of the ability of a business to cut its debts.
A ratio of more than 4 or 5 may suggest that reducing debt could be a struggle – and that the business is less likely to borrow in the future to expand. Analysts also like the enterprise value (EV)/ebitda ratio which shows how expensive a company is.
A low EV/ebidta ratio suggests a company could be undervalued.
To calculate the EV you take the company’s market capitalisation (the total value of its shares), add its debt, subtract its cash and divide it by the ebitda.
When did it become popular?
The term entered business language in the 1980s. But it was first devised in the 1970s by billionaire John Malone, now chairman of Liberty Media, owner of Virgin Media-02. During that period, Malone was rapidly acquiring cable TV companies and needed a measure of their cash-generating ability.
Why is there criticism?
Mab call ebitda a ‘bad number’ or even a ‘fake metric’ because the earnings figure may be distorted. Such is the length and complexity of companies’ financial statements that managers can easily bury issues relevant to earnings in the small print. As a result of this ploy, the number could be overstated.
Are these criticisms fair?
Ebitda has its limitations, so the main thing is to be aware of them. Never look at any single measure or ratio in isolation, but try to build a rounded picture of a company’s finances.