# EBITDA

Guide to Understanding the Concept of EBITDA

## How to Calculate EBITDA

EBITDA stands for “Earnings Before Interest, Taxes, Depreciation and Amortization”.

The practice of companies disclosing non-GAAP earnings to offer more insight into their recent operational performance and financial position has become rather common in recent years.

The goal in doing so is to provide enhanced transparency into the actual performance of the company (with such non-GAAP measures presented as supplementary material).

EBITDA reflects a company’s core operating profits, i.e. revenue minus all operating expenses except for non-cash items, namely depreciation and amortization (D&A).

EBITDA excludes non-cash expenses, namely depreciation and amortization, as the recognition of those items on the income statement is related to the accrual accounting reporting standards established under U.S. GAAP.

Since the goal of EBITDA is to provide a normalized view of financial performance, the outcome should, at least in theory, result in more accurate projections.

While GAAP metrics such as operating income (EBIT) and net income strictly abide by GAAP reporting standards, equity analysts and investors alike often pay more attention to non-GAAP metrics such as EBITDA.

Non-GAAP metrics are not reported on a company’s financial statements directly – i.e. EBITDA cannot appear on the income statement – yet companies still frequently present their non-GAAP metrics in management presentations and press releases, as well as mention them on earnings calls.

## Adjusted EBITDA vs. EBITDA

The formula for calculating EBITDA, at its simplest, is the sum of operating income (i.e. EBIT) and D&A.

D&A stands for “depreciation and amortization”, and represents a non-cash add-back on the cash flow statement.

• Depreciation → A non-cash expense recognized to reduce the carrying value of a company’s property, plant & equipment (PP&E) over its estimated useful life assumption.
• Amortization → Virtually identical to depreciation, the only distinction of amortization is that the incremental reduction is applied to the company’s intangible assets across its estimated useful life as opposed to its fixed assets.

On the income statement, the D&A expense is rarely broken out in its own separate line item and is instead typically embedded within either cost of goods sold (COGS) or operating expenses.

In order to obtain the entire depreciation and amortization expense of a company, refer to the cash flow statement (CFS), as the non-cash items will be added back to net income as part of the cash reconciliation.

However, the process of calculating EBITDA can easily become more intricate due to the treatment of items such as stock-based compensation (SBC), which is often called “Adjusted EBITDA”.

The add-backs to determine a company’s adjusted EBITDA are discretionary, and some examples of such non-recurring adjustments include the following:

• Restructuring (RX) Fees
• Litigation Settlements and Legal Fees
• Impairments, i.e. Write-Downs / Write-Offs
• Gains / (Losses) on Sale of Assets
• Severance Packages
• Income / (Expenses) from Discontinued Operations

Note: The treatment of stock-based compensation (SBC) – a non-cash item that creates additional dilution – is a rather complex subject that is discussed in more detail in the following post → Stock-Based Compensation in DCFs

###### Management-Adjusted EBITDA in M&A

In M&A, a pitch deck or confidential information memorandum (CIM) in practically all cases will contain a management-adjusted EBITDA figure.

Starting from EBIT, any adjustments for non-recurring income or expenses are made to get a better sense of the normalized core profitability of the company. Oftentimes, the management-adjusted EBITDA is used by prospective buyers in the preliminary stages of the process until the deal reaches the later stages, during which additional in-depth diligence ensues.

In the diligence phase, the buyer – either a strategic acquirer or financial buyer (i.e. private equity firm) – delves into the financials of the target company on a far more granular level.

If deemed necessary, the buyer can also hire an independent, third-party firm (typically an accounting firm) to perform a routine quality-of-earnings (QofE) analysis to validate management’s adjustments.

## EBITDA Formula

Since EBITDA is a non-GAAP measure, there is no consistent set of rules dictating the specific items that belong in the metric.

Nevertheless, the most common approaches to calculate EBITDA are as follows.

###### EBITDA Formula
• EBITDA = Revenue – Cost of Goods Sold (COGS ) – “Normalized” Operating Expenses
• EBITDA = Operating Profit (EBIT) + Depreciation & Amortization (D&A)
• EBITDA = Net Income + Taxes + Interest Expense + D&A

The term “normalized operating expenses” refers to a company’s operating expenses, such as selling, general and administrative (SG&A) costs and research and development (R&D), but excludes non-cash expenses like depreciation and amortization (D&A).

If the starting point is net income, i.e. the “bottom line” of the income statement, the steps to calculate EBITDA would involve adding interest, taxes, and non-cash items.

• EBIT = Net Income + Interest + Taxes
• EBITDA = EBIT + Depreciation & Amortization (D&A)

The widespread usage of the EBITDA metric is largely due to the metric being capital structure independent and unaffected by differences in taxes, which is jurisdiction-dependent and can be skewed by items such as net operating losses (NOLs).

###### EBITDA Margin

EBITDA can be divided by revenue in the corresponding period to arrive at the EBITDA margin, which is a standard measure of profitability used across a broad range of industries.

• EBITDA Margin = EBITDA ÷ Revenue

The EBITDA margin answers the following question:

“For each dollar of revenue generated, what percentage of it trickles down to EBITDA?”

The ratio between EBITDA and revenue expressed as a percentage (i.e. the EBITDA margin) can determine a company’s operational efficiency and capacity to produce sustainable profits over the long run.

## Non-GAAP EBITDA Reconciliation

Forecasting EBITDA starts with the reconciliation of EBITDA in the historical periods.

Certain companies disclose EBITDA in their public filings such as in management presentations and press releases ahead of their earnings report.

However, our recommendation is to ignore management’s figure, at least during the initial stages of analysis, and to instead calculate the company’s EBITDA independently.

Once complete, the independently calculated metric can be compared to management’s guidance as a quick “sanity check,” but the more important point is to avoid overreliance on management estimates.

The management teams of companies, especially if publicly traded, are inclined to illustrate the financial state of their company in the best light possible, making it critical to remain skeptical to avoid being misled.

## Pros/Cons of EBITDA

EBITDA often receives criticism for showing an inaccurate and misleading representation of a company’s actual cash flows.

The absence of consistency among which items should be included (or excluded) from EBITDA makes it necessary to question the rationale of each adjustment on its own.

EBITDA Pros EBITDA Cons
• Easy to Calculate (”Back of the Envelope”) and Widespread Usage
• Often Criticized as an Inaccurate Proxy for Operating Cash Flow
• Adds-Back Non-Cash Items, e.g. Depreciation & Amortization (D&A)
• Even with the Add-Back of D&A, EBITDA Remains Prone to the Shortcomings of Accrual Accounting
• More Appropriate for Asset-Lite Companies with Minimal Capital Expenditures Requirements
• Less Appropriate for Asset-Heavy Companies in Capital Intensive Industries
###### Limitations to EBITDA

The primary source of criticism surrounding EBITDA is the lack of consideration towards capital expenditures (Capex).

For most companies, capex is a major, recurring cash outflow that is captured on the cash flow statement but does not directly appear on the income statement.

Instead, the capex spend is allocated across the useful life assumption of the fixed asset (in the form of D&A) because the purchased asset is anticipated to provide monetary benefits in excess of one year.

While a negligible issue for certain companies, for others the disconnect between EBITDA and free cash flow (FCF) can be substantial (i.e. for asset-heavy companies) and reflects one of the shortcomings of EBITDA.

## Forecasting EBITDA – Top-Down vs. Bottom-Up Bridge

Forming an opinion on the discretionary adjustments to EBITDA not only reduces the risk of inflating the metric but also improves the forecasting of EBITDA.

There are two methods in which EBITDA can be forecasted:

1. Top-Down EBITDA: Forecasted EBIT + D&A
2. Bottom-Up EBITDA: Forecasted Net Income + Taxes + Interest Expense + D&A

The top-down approach begins with operating income (EBIT) from the income statement and adds back D&A from the cash flow statement.

On the other hand, the bottom-up approach starts with net income and adds back taxes and the interest expense to arrive at EBIT, with the final step consisting of adding back D&A.

## EBITDA vs. EBIT

EBIT, or operating profit, is an accrual-accounting-based GAAP profit measure, whereas EBITDA is a non-GAAP, hybrid profit metric.

EBITDA and EBIT are two pre-tax, capital-structure-neutral profit metrics that share numerous commonalities.

• EBITDA: “Earnings Before Interest, Taxes, Depreciation and Amortization”
• EBIT: “Earnings Before Interest and Taxes”

The difference between the two metrics is contingent on the industry (or is company-specific).

In certain scenarios, the difference between the two will be marginal, whereas the difference can be “night and day” in other cases (i.e. capital-intensive companies with significant D&A).

• EBITDA → EBITDA is revenue minus all operating expenses except for non-cash items (D&A).
• EBIT → EBIT is revenue minus all operating expenses, including non-cash items (D&A).

The exclusion of depreciation and amortization in the case of EBITDA (or inclusion for EBIT) is the primary differentiating factor between the two metrics.

A company with D&A recognized in the current period will possess a lower operating margin than EBITDA margin.

## Importance of EBITDA in Valuation

In practice, EBITDA as a profit measure is the most widely used metric in corporate valuation.

The prevalence of EBITDA in valuation multiples is tied to the “unlevered” aspect of the metric, wherein the effects of financing and taxes are excluded.

Irrespective of the capital structure of the company – i.e. the reliance on debt or equity to fund day-to-day operations and purchases – comparisons among companies with different capitalizations are still feasible.

EBITDA adds back D&A to remove its effects, so the metric is also not distorted by a non-cash expense that can be substantial for certain companies, such as those operating in capital-intensive sectors, e.g. manufacturing, industrials, and telecom.

Since EBITDA removes the impact of one-time, extraordinary items and is considered a capital-structure neutral metric, comparisons among different companies are easier (and closer to being “apples-to-apples”).

## EV/EBITDA Multiple

One of the most common valuation multiples is the EV/EBITDA multiple, which compares the total value of a company’s operations (EV) relative to its EBITDA.

With that said, EBITDA in valuation multiples is particularly useful for capital-intensive companies, where a significant amount of capital is allocated to the purchase of fixed assets.

Given how D&A is a direct function of a company’s capital expenditures, companies with asset-heavy business models are susceptible to periodic fluctuations in performance that can skew GAAP financial results.

The EV/EBITDA multiple answers the following question:

• “For each dollar of EBITDA generated, how much are the company’s investors currently willing to pay?”

In order to compute a company’s enterprise value (TEV) using the EV/EBITDA multiple, the company’s EBITDA is multiplied by the EBITDA multiple to arrive at the implied valuation.

###### EV/EBITDA Multiple Formula
• EV/EBITDA Multiple = Enterprise Value ÷ EBITDA
• Enterprise Value = EBITDA × EV/EBITDA Multiple

## EBITDA Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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## GAAP Income Statement Build

Suppose a company generated \$100 million in revenue for its latest fiscal year, 2021.

The operating costs incurred by the company were \$25 million in COGS, \$20 million in SG&A and \$10 million in R&D.

By subtracting COGS from revenue, we can calculate our company’s gross profit.

• Revenue = \$100 million
• COGS = –\$25 million
• Gross Profit = \$100 million – \$25 million = \$75 million

The next profit metric to calculate is EBIT, which is equal to gross profit minus operating expenses, i.e. the SG&A and R&D expenses in our scenario.

• SG&A = –\$20 million
• R&D = –\$10 million
• EBIT = \$75 million – \$20 million – \$10 million = \$45 million

From the operating income line, the next section is the non-operating income / (expense) section, where our only item is \$5 million in interest expense.

If the interest expense is deducted from EBIT, we are left with earnings before taxes (EBIT), otherwise known as the pre-tax income.

• Interest Expense = –\$5 million
• EBT = \$45 million – \$5 million = \$40 million

Only one step is left before we reach our company’s net income, which is calculated by subtracting taxes from EBT.

Here, we’ll assume a tax rate of 20% and multiply that by our EBT, which comes out to \$8 million in taxes

After subtracting the tax expense from EBT, we conclude that the net income of our company is \$32 million.

• Taxes = –\$8 million
• Net Income = \$40 million – \$8 million = \$32 million

## EBITDA Example Calculation

Our next section is comprised of two parts, where we’ll calculate the EBITDA of our hypothetical company using the income statement built in the previous section.

But before we can calculate EBITDA, we’re missing one key assumption: depreciation and amortization (D&A) expense.

If we assume the D&A expense in 2021 is \$5 million, what is the EBITDA of our company?

Under the “top-down” approach, we’ll start by linking to EBIT from our income statement and adding back the \$5 million in D&A, which equals \$50 million in EBITDA.

By dividing our company’s EBITDA by revenue, the EBITDA margin is 50%.

• EBITDA = \$45 million + \$5 million = \$50 million
• EBITDA Margin = \$50 million ÷ \$100 million = 50%

In contrast, the “bottom-up” approach starts with net income, i.e. the profit metric inclusive of all operating and non-operating expenses found at the bottom of the income statement.

From net income, we’ll add back taxes, interest expense and D&A to arrive at an implied EBITDA of \$50 million (and EBITDA margin of 50%), which confirms our prior calculation is, in fact, correct.

• EBITDA = \$32 million + \$8 million + \$5 million + \$5 million = \$50 million

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