Why EBIT or EBITDA?
One of the common questions we get asked is why does the term EBIT or EBITDA get used so frequently in valuation work?
EBIT stands for Earnings Before Interest and Taxes (EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortisation).
EBIT is sales less expenses (including depreciation) adding back any interest paid and subtracting any interest received. The only change to EBITDA is that depreciation and amortisation are added back.
Why EBIT or EBITDA? Why not use net profit after tax or some other measure?
In valuation we are trying to determine a reasonable estimate of cash flows and a base level of profitability for a business that is easily comparable – cash flow for discounted cash flow modelling and base profitability to complete comparator analysis. EBIT is the corporate finance best estimate for a firm’s cash flow. EBIT also strips out the two key differing elements that make figures like net profit after tax hard to compare between different companies – capital structure and tax position. We start with these.
Capital structure describes the mixture of debt and equity that a company uses to finance its operations. With more debt (also called leverage) on a company’s balance sheet – the more interest it pays (typically). The interest cost is included in figures like net profit after tax and can skew comparisons between virtually identical companies – where the only difference is in the amount of debt held by one company. Different prior earnings histories can also impact figures like net profit after tax. Again if we have two identical companies today – one that has a history of losses and one that has always been profitable – in all other aspects the companies are identical with the same prospects moving forward. At the net profit after tax level one company (the one with a history of losses) will have a higher figure than the other – as it will have been able to use its tax losses to off-set current profits and reduce its current tax bill. Again this skews comparisons – so taxes are eliminated from the EBIT figure.
The difference between EBIT and EBITDA is depreciation and amortisation – why include or exclude depreciation and amortisation? In both cases we are trying to estimate a base level of cash flow from the business. The two key components of calculating this base level of cash flow are the profits that the business produces and the on-going investments required by the business to achieve these cash flows – the capital expenditure that the company needs to undertake to achieve the profitability. EBIT includes depreciation and amortisation, which are not cash items, but that act as estimates (imperfect – but an estimate) of capital expenditure. EBITDA removes depreciation and amortisation and thus just focuses on the profitability of a company without considering the investment required to achieve the profitability.
Depreciation and amortisation are accounting treatments that spread the cost of capital expenditure items over the term of the assets (either tangible or intangible) useful life.
The argument for using EBITDA over EBIT is that for some companies with limited capital expenditure (i.e. software firms) the figure is immaterial. I don’t agree with this analysis – I have done a lot of work with companies that have this, so called, limited capital expenditure requirement and there is always some capital expenditure required. I am against using EBITDA over EBIT in valuation exercises. In a valuation you need to take into account the capital expenditure required to capture a base level of profitability. EBITDA can be a useful number for other reasons – away from valuation.
In the Valuecruncher model we utilise EBIT as our base estimate of cash flow but request information about both depreciation and capital expenditure to better estimate cash flows from a business.