Last Updated on May 25, 2022 by Neera Bhardwaj
You may have often heard financial news anchors say statements such as – “ The company’s EBITDA continues to grow but however due to increasing capex over the last few quarters, the net income and EPS have fallen sharply”.
Or more recently, you may have seen investors on the show ‘Shark Tank’ ask startup founders – “Is your startup EBITDA positive? What was your EBITDA for the last 12 mth?”
Keeping pace with the plethora of abbreviations in the world of investments can be overwhelming, so today, let’s understand a commonly used financial metric – EBITDA.
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What is EBITDA?
EBITDA stands for Earnings before Interest, Tax and Depreciation, and Amortisation.
EBITDA is an indicator of the operational efficiency of the company and considers the earnings after deducting operating expenses that are crucial in running the business. In other words, it is primarily what a company earns directly from its operations/services without accounting for expenses like tax, interest, depreciation, and amortisation.
It is widely regarded as a good indicator of a company’s performance and is hence often used while evaluating a stock’s investment potential.
To simplify EBITDA, let’s look at it with an example.
Assume, company ABC Ltd makes Rs. 1000 cr. in revenue for the current year. Now, this amount is not the full earning or profits of the company. ABC Ltd will need to make payments towards purchasing raw materials to produce or deliver the goods, pay salaries to employees, clear invoices of vendors, and so on. These are all expenses. Now, if the sum total of all these expenses comes to Rs. 200 cr., then, we can conclude that ABC Ltd’s EBITDA stands at Rs. 800 cr.
But, these are not the only expenses ABC Ltd or any company will, for that matter, incur. Every enterprise also has to account for taxes, interests (if any loans), and also for depreciation and amortisation. All of these deductions are made to the EBITDA figure to arrive at the net income/profit/ PAT (profit after tax) of a company, which is the actual earnings the company makes in a financial year.
Hence, to understand EBITDA, you should understand the various nuances of expenses associated with a company. Here is loosely how to calculate EBITDA and how it helps determine the earnings or net profit of a company.
- Cost of raw materials
- Other expenses including salaries, bills, and so on
= EBITDA or Gross Profit
- Depreciation and amortisation
= PBT (Profit before tax)
= PAT (Profit after tax) or Net Profit/Net Income
How to calculate the EBITDA?
While analyzing a company, look at its financial statements – specifically the income statement to calculate EBITDA.
EBITDA can be calculated in two ways as below:
Begin from net income: You can start from the bottom of the income statement, i.e., the net income figure, and add back – taxes, depreciation and amortization, and interest expenses.
Begin from revenue: Alternatively, you can begin from the revenues earned and start subtracting expenses such as cost of goods sold, advertising expenses, and operating expenses. Make sure to not discount the tax expenses. Once done, you shall arrive at the EBITDA of the company.
How is EBITDA useful while analyzing stocks?
As explained above, EBITDA is useful in understanding a company’s operational efficiency but you also gain numerous insights as below about the stock through EBITDA analysis.
Understanding the business model: Before investing in any stock, understanding the company’s business model is crucial because there lies the source of the expected stock returns.
Here is an example:
Two companies may have the same net profit (say Rs. 10 cr.) but may have different EBITDA (say Rs. 12.5 cr. and Rs. 13 cr.).
The EBITDA here is calculated by starting from the net profit and adding back the relevant line items. While looking at the net profit, it may appear that Company A and Company B have the same financial position but key differences in their business model may be ignored if the EBITDA is not analysed.
In the example:
- Company A has a lower tax expense, perhaps due to the differences in countries of operation
- Company B has a lower interest expense attributable either to lower debt or cost of funding
- Company A has lower depreciation and amortization expenses due to their business model and corresponding asset base
EBITDA analysis not only helps you gain insights on the company you plan to invest in, but allows you to compare the core operating performance of various companies and thereby their stocks.
Ability to pay interest
Since EBITDA considers earnings from operating activities only, it is a good indicator of the amount available with the company to repay its debt. While undertaking stock analysis, a low EBITDA against a high pending interest expense may be a point of caution.
Value for all stakeholders
One might argue that why do we need to undertake EBITDA analysis when the net income is available to us? While that is a fair point, it is important to understand that net income subtracts the interest component (earnings for debt holders). This implies that net income is accrued only to the equity stakeholders of the company.
This is the reason why stocks are often valued as a multiple of EBITDA because it reflects the earnings available to all stakeholders rather than purely equity shareholders.
A higher EBITDA indicates greater financial strength of the company arising from superior operating performance. Understanding the EBITDA of a company can go a long way in giving you a bird’s eye view of the company, whether you should invest in it’s stock and how it performs in comparison to peers.