What is EBITDA and why is it used?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Often, it is a key metric used in valuing a company. Many people use EBITDA as a proxy for cash flow available to pay investors, both debt and equity. EBITDA is a variation of what many refer to as operating income or Earnings Before Interest and Taxes (EBIT). The reason for the additional adjustments is it removes items that are considered at the “owner’s discretion,” at least to a certain extent. Examples maybe: debt financing, capital structure, methods of depreciation, and income taxes.
The Formula:
EBITDA = Net Income + Interest + Income Taxes + Deprecation + Amortization
OR
EBITDA = EBIT + Depreciation + Amortization
Interest
Interest is excluded as it removes the debt component of the company’s current capital structure. Allowing the valuator to adjust for optimal or industry levels of debt based on the interest being valued. This also allows analysts to more easily compare companies by removing their various amounts of debt from the comparison.
Income Taxes
Taxes vary from company to company based several factors. One key factor is entity formation: C Corporation, S Corporation, LLC, or Partnership. Also, the region or state the company operates in may have varying levels of state and local taxation.
Depreciation & Amortization
Depreciation and amortization (D&A) vary based on amount, time, and accounting/tax methods for the expensing of capital expenditures over time. These characteristics are heavily based on useful lives of capital assets. While some investors, such as Warren Buffet, do not care for EBITDA due to its add back of D&A it can be a great starting cash flow analysis for comparability, allowing the analyst to review and adjust for actual cash outflows for capital expenditures rather than depreciation assumptions.
Why use EBITDA?
First, it can assist the analyst in performing quick estimates of value through the market approach by applying multiples from equity research, industry transactions, or other M&A measures. Additional, when a company is not making money for income tax purposes. The addbacks can allow the analyst to compare the business to others of similar size and in the same industry. Using EBITDA as a starting cash flow helps to remove the historical ownership choices in order to evaluate the future choices based on the standard and premise of value.
Disadvantages of EBITDA?
EBITDA is not recognized by GAAP or IFRS, and some investors are skeptical because it presents the company as if it has never paid any interest, taxes, depreciation, or amortization. But as mentioned above it can be a great starting point for cash flows in an income approach or as a method for use under the market approach if combined with the proper adjustments in arriving at the company’s value.
I’m Gregory M. Clark, MSA, CPA, CVA, MAFF of GMC & Company. I help attorney’s and their clients in litigation matters with business valuation, litigation support, forensic accounting, and consulting. If you have a shareholder dispute, or are going through a divorce and need a business valuation or forensic services, let’s talk! Call us at 219-554-9700 or email us at info@gmcandco.com.
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