Earnings before interest, taxes, depreciation and amortization (EBITDA) is a measure of a company’s profitability before items below the operating line like other income, interest expense and taxes are considered.
The easiest calculation for EBITDA is adding depreciation and amortization expenses to operating income, or earnings before interest and taxes (EBIT).
EBITDA is useful when comparing the operating performance of companies in the same industry. The calculation removes differences in capital structure and financing methods in place. This is important when comparing a relatively new or emerging entity against a more established one. A new company, or one performing a restructuring or transformation, may be investing more heavily in operations than a company that is farther along in its evolution.
While the outsized portion of investment and subsequent financing represent real costs to the business, those costs aren’t likely to remain in place forever. The thought is by extracting those nonoperating items from the financial performance, two companies, regardless of their stage of maturity, can be easily evaluated and compared to one another based on their core operating activities.
A key consideration is how long the high level of capital investment will last.
A company spending significantly on real estate and equipment in efforts to ramp up a new service or line of business will incur much larger depreciation expenses than one that is not. By stripping out the expenses, core operating activities are more fairly compared.
Many valuation metrics use EBITDA for those very reasons.
Equity analysts use EBITDA when establishing stock price targets on the companies they follow. In addition to using a multiple of earnings per share to create a price target, or price-to-earnings (P/E) multiples, some analysts also value equity off of enterprise value to EBITDA (EV/EBITDA).
Enterprise value is a look at the entire value of a company. The formula is used to measure the takeout price of an entity if it were to be acquired. It includes market capitalization, or the market value of the outstanding equity, plus the debt, which in theory would be repaid to lenders, minus the cash, which the new acquiring company would own.
Some view EV/EBITDA as a more comprehensive method of valuing a newer company or one in the process of a transformation.
Most acquisitions are valued off of a multiple of EBITDA.
Net debt to EBITDA
Also, lending agreements usually establish EBITDA-based requirements and covenants, net debt to EBITDA being the most common. The standards are established by lenders to ensure companies don’t become overleveraged and will be able to service debt loads and meet repayment terms as agreed.
Net debt to EBITDA is also used by credit-rating agencies to assess debt leverage when classifying a company’s credit-risk profile.
Adjusted EBITDA is a commonly seen calculation in many financial reports.
Most often, adjusted EBITDA calculations exclude entries that are believed to be one time or nonrecurring in nature. Examples are: transaction and integration costs associated with acquisitions or divestitures, restructuring costs, severance, expenses incurred from IT conversions and some gains or losses on the disposal of assets.
In trucking, many carriers exclude fuel surcharges from adjusted-margin calculations to compare prior and current periods without the added noise of fluctuations in fuel prices.