What is EBITDA in the Share Market? Learn its Meaning, Formula & Stand in the Stock Market
The EBITDA full form in finance is Earnings Before Interest, Taxes, Depreciation, and Amortization. Considered as a financial metric, the use of EBITDA in the share market is to help investors gauge the financial performance before standard deductions, such as taxes, depreciation, etc.
Therefore, in this blog, we will explore EBITDA meaning, including its formula, benefits, interpretation, and limitations.
What is EBITDA in the Share Market?
EBITDA is a financial metric used to measure a company’s operating performance, independent of its capital structure, tax rate, and accounting decisions. By including depreciation and amortization, taxes, and debt payment costs, EBITDA attempts to showcase the company’s profits.
History of EBITDA
In the 1970s, Liberty Media Chairman John Malone, a notable investor comparable to Buffett, introduced EBITDA to support his leveraged growth strategy. He aimed to attract lenders and investors by minimising taxes through debt and reinvested profits.
By the 1980s, those engaged in leveraged buyouts (LBOs) found Earnings Before Interest, Taxes, Depreciation, and Amortization valuable for assessing whether targeted companies could profitably manage the anticipated debt. EBITDA’s appeal lies in excluding interest, tax, depreciation, and amortization expenses. This facilitates an accurate evaluation of a company’s ability to service debt amid structural and tax changes in a buyout.
LBO buyers, targeting companies with limited near-term capital spending plans, prioritised the EBITDA-to-interest coverage ratio. This ratio, weighing core operating profitability against debt service costs, helped secure financing for acquisitions.
During the dotcom bubble, EBITDA gained attention, but some companies misused it to inflate their financial performance. In 2018, WeWork’s IPO prospectus showcased “Community Adjusted EBITDA,” excluding general and administrative, sales, and marketing expenses, contributing to what is the ‘EBITDA is negative’ publicity.
Why is EBITDA Important?
EBITDA is important in financial analysis because it can be used to track companies’ underlying profitability regardless of the depreciation assumptions. Additionally, it allows a better comparison of companies’ profitability and operational efficiency in the same industry or sector.
However, it is important to note that Earnings Before Interest, Taxes, Depreciation, and Amortization is not a GAAP (Generally Accepted Accounting Principles) recognised metric and should be used with other financial ratios and metrics when analysing a company’s financial health.
EBITDA as a Financial Metric – Explained
EBITDA evaluates a company’s financial performance without considering its capital investments, such as property, equipment, and more. It is not related to debt financing as it solely focuses on the company’s operating decisions. Thus, this all indicates why it may not be an accurate measure of profitability.
Thus, EBITDA in business is widely used by investors, analysts, and creditors to compare the performance of companies in the same industry or sector. It is also a common valuation metric to determine a company’s enterprise value.
Difference Between EBITDA and EBITA
Although they sound similar, EBITDA and EBITA are quite different. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBITA (Earnings Before Interest, Taxes, and Amortization) are both non-GAAP financial metrics. Both are used to evaluate a company’s profitability, efficiency, or value. The main difference between the two is the depreciation value (a decrease in the monetary value of tangible assets as time passes). This distinction is important because depreciation is a non-cash expense that can significantly impact a company’s profitability.
How to Calculate EBITDA?
The formula for EBITDA are as follows:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
or
EBITDA = Operating Income + Depreciation & Amortization
Where
- Earnings: Refers to a company’s total revenue or income before any expenses are deducted.
- Interest: Refers to the cost of borrowing money, such as interest paid on loans or bonds.
- Taxes: This refers to the income taxes paid by a company to the government.
- Depreciation: This refers to the reduction in overall value of the tangible assets from time to time.
- Amortization: Amortization meaning in EBITDA is the cost of intangible assets such as patents or trademarks being spread out over their useful life.
(Note: EBITDA does not take into account capital expenditures or changes in working capital, and should be used in conjunction with other financial metrics when analysing a company’s financial health.)
EBITDA Calculation Example
Suppose an IT company’s financial annual data was pulled out for the year 2022-23. The company’s net income is Rs. 10,00,000, with depreciation and amortization expenses amounting to Rs. 4,00,000. The company also incurred taxes of Rs. 5,00,000 and interest expenses of Rs. 5,00,000, while its operating income stood at Rs. 20,00,000.
So, to calculate EBITDA, we’ll apply the following formula:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
= 10,00,000 + 5,00,000 + 5,00,000 + 4,00,000
= Rs. 24,00,000
Thus, in this example, the company’s EBITDA is Rs. 24,00,000 which shows how much money the company is making after taking into account any interest, taxes, or depreciation costs.
What is Adjusted EBITDA?
Understanding the distinction between EBITDA and adjusted EBITDA is crucial. By standardising income and cash flows and removing irregularities like redundant assets or excessive rent, adjusted EBITDA enables a more straightforward comparison of businesses, irrespective of industry or location differences.
To calculate adjusted EBITDA, apply the following formula:
Adjusted EBITDA = EBITDA + Other Adjustments
Let us understand better with an example of an IT company again.
Based on the above calculation, the EBITDA of an IT company is Rs. 24,00,000 for the year 2022-23.
Now let us extend this example, including two additional expenses incurred by the company during the same period that are mentioned as follows:
- Stock-based Compensation Expenses: Rs. 2,00,000
- Restructuring Charges: Rs. 1,00,000
To calculate the adjusted EBITDA, let’s make adjustments to the EBITDA figure:
Adjusted EBITDA = 24,00,000 + 2,00,000 + 1,00,000 = Rs. 27,00,000
Thus, the adjusted EBITDA of an IT company is Rs. 27,00,000, which reflects an accurate representation of its operating performance by excluding irregularities.
EBITDA Margin & Valuation – Explained
EBITDA Margin represents the relation between a company’s aggregate revenue and its total earnings. It indicates the profit a company generated in one year. Since EBITDA isn’t registered in a company’s financial reports, financial analysts do this manually.
The formula for calculating EBITDA is:
EBITDA = Earnings before Interest, Taxes, Depreciation, and Amortization
Margin = (EBITDA / Aggregate Revenue) x 100%
Suppose that two companies, Company A & Company B calculate their EBITDA margins based on their respective EBITDA and total revenue as follows:
Let’s say Company A has an EBITDA of Rs. 6,00,000, with a total revenue of Rs. 60,00,000. Therefore, the resulting EBITDA margin will be as follows:
Margin = (EBITDA / Aggregate Revenue) x 100%
Margin = (6,00,000/ 60,00,000) x 100%
= 10%
Now, let’s consider the second company, Company B with an EBITDA of Rs. 6,50,000 with a total revenue of Rs. 70,00,000. Thus, the margin would be as follows:
Margin = (EBITDA / Aggregate Revenue) x 100%
= (6,50,000/7,00,000) x100%
= 9.2%
Despite Company B having a higher EBITDA, its EBITDA margin is lower compared to Company A. Based on the results, analysts, potential buyers, investors, and business owners will find Company A to be a more lucrative option regardless of the lesser total revenue and smaller EBITDA.
What is the EBITDA Coverage Ratio?
The EBITDA coverage ratio is a vital financial metric that gauges a company’s financial strength by assessing its ability to cover interest-related expenses with pre-tax income. Calculated as:
EBITDA Coverage Ratio = EBITDA + Lease Payments / Interest Payments + Principal Payments + Lease Payments
A ratio greater than 1 signals strong financial health, indicating the firm can meet its interest obligations and repay liabilities.
Businesses calculate the EBITDA coverage ratio because, unlike the EBITDA margin, this measure is not based on a comparison between different companies. Instead, it provides a standalone measure of a company’s financial health.
What is a EBITDA Multiple Ratio?
The EBITDA Multiple ratio indicates whether a company is overvalued or undervalued. By considering a company’s debt alongside its EBITDA, this ratio provides buyers and analysts with a clearer picture of the company’s financial health and its ability to manage existing debt. A high EBITDA multiple ratio suggests the company might be overvalued, as its EBITDA is relatively low, while a low EBITDA multiple ratio suggests the company might be undervalued.
What are the Uses of EBITDA?
In the 1980s, during the leveraged buyout era, analysing a company’s financial health through Earnings Before Interest, Taxes, Depreciation, and Amortization gained popularity. Investors and lenders used EBITDA to gauge whether distressed companies or those undergoing restructuring could generate enough profitability to service acquisition-related debts.
Today, when used judiciously alongside other accounting metrics, EBITDA remains a significant tool. Therefore, here are a few uses of EBITDA:
Comparing Companies
Focusing on operating profitability and cash flow, EBITDA facilitates straightforward comparisons across different-sized companies in the same industry, cutting through potential distortions caused by short-term issues or accounting manoeuvres.
Cost-cutting Effectiveness
Calculating EBITDA margin is useful for evaluating a company’s success in cost-cutting. A higher EBITDA margin indicates lower operating expenses in relation to total revenue.
Debt Service Coverage Ratio
EBITDA is a key metric in the financial industry. Bankers use it to estimate a company’s available cash flow for long-term debt payments and to calculate the debt coverage ratio.
Business Valuation
EBITDA multiples, typically between 5x and 10x depending on industry factors, barriers of entry, and capital intensity, are commonly used to value businesses. A high multiple may indicate overvaluation, while a low one suggests undervaluation. Unlike other metrics, the advantage of EBITDA multiples lies in their consideration of company debt, such as the price-to-earnings ratio.
Interpretation of EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization is a financial metric that shows a company’s profitability before accounting for interest, taxes, depreciation, and amortization. It is calculated by taking a company’s earnings before interest and taxes (EBIT) and adding back any depreciation and amortization expenses.
EBITDA is one of several financial metrics that investors and analysts use to evaluate a company’s financial health. Some other common metrics are:
- Net Income: This is the total amount of profit a company has earned after accounting for all expenses, including interest, taxes, amortization, and depreciation.
- Free cash Flow: This is the amount of cash a company generates after accounting for all expenses and capital expenditures.
- Return on Equity (ROE): This measures a company’s ability to generate profit from the money invested by shareholders.
Each of these metrics provides different insights into a company’s financial health, and it’s important to consider them together when evaluating an investment opportunity.
To interpret EBITDA, it’s important to keep in mind that it is not a comprehensive measure of a company’s financial health. It does not take into account changes in working capital, capital expenditures, or other important financial factors. Additionally, companies can manipulate Earnings Before Interest, Taxes, Depreciation, and Amortization, using creative accounting practices.
EBT vs EBITDA
Here is a table of comparison between EBT and EBITDA:
| Aspects of Comparison | EBT | EBITDA |
| Definition | Measures operating profits before taxes are considered. | Measures operating profits before interest, taxes, depreciation, and amortization. |
| Full- form | Earnings Before Taxes | Earnings Before Interest, Taxes, Depreciation, and Amortization |
| Purpose | Evaluates operational performance after excluding tax liabilities. | Assesses operational efficiency by excluding interest, taxes, depreciation, and amortization. |
| Tax Consideration | Includes taxes in the calculation, representing the earnings available after tax. | Excludes taxes, providing a pre-tax view of operational profitability. |
| Interest Expenses | Interest expenses are included in the calculation. | Interest expenses are excluded from the calculation. |
EBIT vs EBITDA
Here is a tabular comparison of EBIT and EBITDA:
| Aspects of Differences | EBIT (Earnings Before Interest and Tax) | EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) |
|---|---|---|
| Components Included | Earnings without interest and tax impact | Earnings without interest, tax, depreciation, and amortization impact |
| Scope of Analysis | Limited to interest and tax exclusion, calculated using the EBIT formula. | Extends beyond interest and tax, also excludes depreciation and amortization |
| Comprehensive View | Offers a view of operational profitability | Provides a broader perspective, excluding non-cash expenses |
| Usefulness in Valuation | Useful for assessing operational earnings | Valuable for a more holistic view, separating cash and non-cash expenses |
| Business Expense Breakdown | Breaks down interest and tax implications | Further breaks down depreciation and amortization effects |
| Impact on Company Worth | Aids in understanding the core profitability | Assists in understanding overall financial health, considering all major expenses |
| Decision-Making Support | Helps in financial decision-making | Provides enhanced insights for strategic decision-making |
Operating Income vs EBITDA
| Aspects of Comparison | EBITDA | Operating Income |
|---|---|---|
| Treatment of Interest and Taxes | Calculates income before expenses, taxes, depreciation, and amortization. | Calculates profit after operating expenses, excluding interest and taxes. |
| Earning Potential vs. Revenue | Measures total earning potential before specific deductions. | Reflects revenue that can be converted into profit. |
| GAAP Status | Not an official GAAP measure; used for projecting earning capacity. | Official GAAP measure; adjustments not allowed. |
| Applicability and Comparisons | Popular for diverse companies; applicable across sizes, structures, taxes, and interests; enables comparisons. | Represents income from operations; focuses on differences from net income due to other income sources. |
| Calculation Method | Can be calculated by adding depreciation and amortization to EBIT or by adding interests, taxes, depreciation, and amortization to net profit. | Calculated by subtracting operating expenses from gross income. |
Advantages of EBITDA
Here are the some of the advantages of EBITDA:
- Evaluates the Operating Performance of a Company: EBITDA evaluates a business’s core operational performance by excluding non-operational factors such as interest and taxes. This makes it a valuable metric for assessing how effectively a company is managing its day-to-day operations.
- Provides an Accurate Picture of a Company’s Profitability: By using EBITDA, you can get a more accurate picture of a company’s profitability because it excludes non-operating expenses that can skew the company’s earnings. EBITDA also helps to eliminate the impact of accounting practices on earnings.
- Comparative Analysis Across Different Industries: Acts as a common ground for comparing the profitability of companies across various industries. By excluding the effects of tax rates and financing structures, analysts can use EBITDA to facilitate more meaningful comparisons.
- Useful for Analysing Companies with High Debt Levels: EBITDA is also useful for analysing companies with high debt levels because it measures their ability to generate cash flow to pay back the debt. By using EBITDA, one can evaluate the company’s ability to service its debt without the influence of accounting practices.
Limitations of EBITDA
Here are some of the limitations of EBITDA:
- Does Not Consider Capital Expenditures: EBITDA does not consider the capital expenditures required to maintain or grow a company’s operations. It only focuses on the operating performance of the company.
- Can be Manipulated by Companies: EBITDA can be manipulated by companies to make their financial performance look better than it actually is. For example, a company may use aggressive accounting practices to inflate their EBITDA. Therefore, you should carefully evaluate a company’s financial statements in detail to make a sound decision.
- Not Recognised by GAAP: EBITDA does not follow the standard accounting principles and practices outlined by GAAP. GAAP is a set of rules and guidelines that govern how financial statements are prepared and presented, and EBITDA does not conform to these standards.
To Wrap It Up…
To conclude, EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and it can be a useful way to measure how efficiently a company is operating and how much of its earnings are attributed to its operations when compared to the competitors.
Frequently Asked Questions on EBITDA
The Debt to EBITDA ratio refers to a company’s debt repayment capacity by dividing its liabilities by EBITDA. A lower ratio suggests better debt-paying ability, while a higher ratio serves as a warning to potential buyers, indicating difficulty in promptly clearing debts.
Good EBITDA depends on the industry and the company’s circumstances. Generally, a higher EBITDA is seen as favourable because it indicates strong operational profitability. However, what is considered “good” can vary significantly among companies.
By amortization definition, it is an accounting method that gradually reduces the recorded value of assets like patents, trademarks, or goodwill from acquisitions rather than physical assets over time.
Generally Accepted Accounting Principles (GAAP) do not govern EBITDA as a metric for financial performance. As it lacks a standardised calculation method, resulting in variations across companies.
Gross profit focuses on a company’s direct production costs, such as raw materials and direct labour. EBITDA, on the other hand, is an essential profitability metric that accounts for all operating expenses.
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