EBITDA is one of those terms that is getting increased usage, but usually for the wrong reason.  This article will define it and discuss how it can be useful and misleading.

Defined:

EBITDA is an abbreviation for Earnings before Interest, Taxes, Depreciation and Amortization.  It is calculated by taking operating income and adding back interest, depreciation and amortization expenses.  It is used to analyze a company’s operating profitability before non-operating expense (such as interest and “other” non-core expenses) and non-cash charges (depreciation and amortization). 

The Good:

EBITDA can be used to analyze the profitability between companies and industries.  Because it eliminates the impact of financing and accounting decisions, using EBIDTA provides a good “apples-to-apples” comparison.  For example, EBITDA as a percent of sales can be used to find companies that are the most efficient operators (the higher the ratio, the higher the profitability) in an industry. 

The ratio can also be used to evaluate industry trends over time.  EBITDA can be used to compare the profitability trends of “heavy” industries (like automobile manufacturers) to hi-tech companies because it removes the impact of interest expense and depreciation from the analysis. 

The new accounting rules that eliminate the amortization of goodwill (formally know as FAS 142) will bring operating income closer to EBITDA, but EBITDA will continue to be a better measure of core operating profitability.

The Bad:

EBITDA is good metric to evaluate profitability, but not cash flow.  Unfortunately, EBITDA is often used as measure for cash flow, which is a very dangerous and misleading thing to do because there is a significant difference between the two.

Operating cash flow is a better measure of how much cash a company is generating because it takes net income and adds back non-cash charges (depreciation and amortization) and includes the changes in working capital that also use/provide cash (such as changes in receivables, payables and inventories).  These working capital factors are the key to determining how much cash a company is generating.  If investors do not include changes in working capital in their analysis, but rely on EBITDA, they will miss clues that indicate that a company is really losing money because it cannot sell its products!

The Ugly:

It gets ugly when EBITDA is used as a key measure when making investment decisions.  Because it is easier to calculate, EBITDA is often used as a headline metric in discussing a company’s results.  However, as discussed above, this could misrepresent the true investment potential of a company because it does not accurately reflect a firm’s ability to generate cash. 

Summary:

EBITDA is a good measure to use to evaluate the core profit trends, but cash is king.  EBITDA can be used to evaluate the profit potential between companies and industries because it eliminates some of the extraneous factors and allows a more “apples-to-apples” comparison.

EBIDTA is not a good measure for cash flow because it does not include changes in working capital, which are importation and significant.  Cash is king because it shows “true” profitability and a company’s ability to continue operations.

The W.T. Grant Company provided a good illustration of the importance of cash generation versus EBITDA.  Grant was a general retailer, in the time before malls, and was a blue chip stock of its day.  However management made several mistakes, inventory levels increased, and the company needed to borrow heavily to keep its doors open.  Because of the heavy debt load, Grant eventually went out of business.  The top analysts of the day missed the negative cash flows because they were focused on EBITDA.  Wall Street’s recommendations for Grant mirror many of the missed calls of the end of the dotcom era.  History does repeat itself. 

Richard J. Wayman, CFA is President of researchstock.com, an independent, fee-based, equity research firm that focuses on under-followed small cap stocks.  A professional analyst with over twenty years of investment experience, his reports have appeared in Barron's, the Wall Street Journal, forbes.com, Investopedia.com and MultexInvestor.  He is an active member of the CFA Institute and Research and is a former President of the Columbus Society of Financial Analysts.  Rick can be reached at rwayman@researchstock.com.

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