What is EBITDA and Why is it Used by Financial Professionals?
EBITDA — earnings before interest, taxes, depreciation, and amortization — is a measure of a company's operating performance that is not affected by financing decisions or non-cash expenses.
As the chart below indicates, EBITDA is a relatively new financial metric, having gained popularity over older modes of analyzing financial performance.
EBITDA has become an increasingly popular financial metric. Source: Google Ngram Viewer
EBITDA is often used by financial professionals to compare companies across industries because it provides a more consistent measure of profitability. For example, two companies in different industries may have different levels of debt, which could affect their reported earnings. EBITDA is not affected by debt, so it can be used to compare the profitability of these two companies on a more equal footing.
In addition, EBITDA is not affected by non-cash expenses, such as depreciation and amortization. These expenses are incurred to reflect the wear and tear on a company's assets, but they do not represent a cash outflow. As a result, EBITDA can be used to get a better sense of a company's true profitability.
The applicability of EBITDA across companies with different financial characteristics allows it to be paired with company valuations to produce a multiple. A company's EBITDA multiple is equal to its Enterprise Value divided by its EBITDA. Companies with higher rates of growth, higher quality revenue, and stronger competitive positioning tend to have at higher multiples.
Whereas a construction company may trade at a 3x multiple, a fast-growing technology enabled services company with recurring revenue may trade at above a 10x multiple. The size of the company also matters — larger companies trade at higher multiples than smaller ones because larger companies are generally regarded as safer investments due to their scale and perceived financial stability.
There are a few limitations to using EBITDA. First, it does not take into account a company's capital structure. This means that two companies with the same EBITDA could have very different levels of debt, which could affect their financial strength.
Second, EBITDA does not take into account a company's taxes. This means that two companies with the same EBITDA could have very different levels of tax expense, which could affect their profitability.
As a result, some investors do not think highly of the incorporation of EBITDA into the financial lexicon, including Warren Buffett, who noted in a 2003 annual shareholder meeting that, "Any management that doesn't regard depreciation as an expense is living in a dream world."
Despite these limitations, EBITDA is a useful measure of profitability that is often used by financial professionals to compare companies across industries.
Michael Mauboussin, What Does an EV/EBITDA Multiple Mean?
Overview of EBITDA by the Corporate Finance Institute