By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)
Walkthrough
EBITDA is a commonly used profitably metric introduced by billionaire investor John Malone in the 1980s. It stands for Earnings BEFORE Interest, Taxes, Depreciation, and Amortisation. EBITDA is a non-GAAP accounting term, meaning that it does not align with “Generally Accepted Accounting Principles”, and thus will not appear on many companies’ financial statements. Nevertheless, some management teams will include it as it can be considered as a loose proxy for cash flow. Thus, EBITDA is often used in various multiple based valuation methodologies, with the most common being EV / EBITDA.
EBITDA is calculated by starting from Net Income, and adding back interest and tax expenses, followed by adding back depreciation and amortisation.
Amortisation & Depreciation
Depreciation is a non-cash expense that allocates the cost of a tangible asset over its useful life. A tangible asset is a physical asset that you can touch (i.e: PP&E).
Amortisation deals with allocating the cost of an intangible asset. An intangible asset is an asset that you cannot physically touch (ex. Patents, Trademarks, and Goodwill).
The most commonly used method of calculating depreciation and amortisation is the Straight Line Method. It is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used.
Important to note that in accounting both Land and intangible assets with an infinite useful life will never be depreciated or amortised.
Pros & Cons
Pros: EBITDA is a useful metric when trying to compare companies with vastly different tax treatments and capital structures. As we are looking at Earnings before Interest and Taxes, it removes the effect of debt financing (capital neutral) and companies with different tax treatments.
EBITDA is a useful metric for capital intensive industries where significant amounts of capital expenditure is needed. This is because EBITDA focuses on operational performance without the impact of depreciation.
EBITDA is considered to be a quick and easy way to roughly measure cash flow due to the add-back of non-cash expenses such as depreciation and amortisation. An important metric for investors as it reveals how much cash is being generated from the business’ operations.
Cons: While being a proxy for cash flow, it ignores the effects of changes in net working capital (Current Assets - Current Liabilities) as well as other non-cash expenses such as stock-based compensation. Thus, making it an inaccurate depiction of the cash generated from operations.
EBITDA is often adjusted or manipulated. As EBITDA has been popularised on Wall Street, many companies seek ways to adjust EBITDA, by varying what expenses to include in their accounting process, to inflate the financial performance and valuation of their company. Additionally, as it is a non-GAAP metric, there is a lack of standardisation that hinders the comparison between companies.
Different industries and companies may have varying levels of reliance on factors excluded from EBITDA. Retailers and Airlines for example will often have significant lease obligations due to the nature of their businesses, making EBITDA less useful as it excludes an important factor in the business’ model.
Bonus
Billionaire investor John Malone popularised the idea of using EBITDA when valuing companies. Malone loved using debt to grow and hated paying taxes. He thus aimed to maximise his interest and depreciation expenses to minimise his tax bills. However, this lowered his earnings, a key metric that investors and lenders use to value companies. Thus, he convinced them to focus on cash flow instead of earnings, by using EBITDA as a quick and easy proxy.