EBITDA: To Care or Not to Care?

EBITDA is information that is commonly used in evaluating the potential of a company. Some investors love this calculation, while others do not put any weight into it. Here are a few things to consider about whether you should care about EBITDA and how to use it.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. The calculation for EBITDA is fairly simple. To calculate it, you are going to add depreciation and amortization to operating income. This gives you an idea of how the company operates without having to pay unrelated business expenses such as interest and amortization.

The Value

Many investors put a lot of weight into this calculation. If you look at EBITDA as a valuable metric, you have to believe that it gives you a good indication of how efficiently the business operates. When you look at the data that is provided by this calculation, you get a picture of how much cash is available. This is not the same as cash flow, but it does tell you how much money a company makes when they do not have to pay interest, taxes, depreciation and amortization. Many people believe that this can tell you a lot about the company's profitability. Some investors see this cash as a good indication of how the company is going to be able to pay off their debts. 

The Drawbacks

Even though some investors love this calculation, others believe that it is completely worthless. In some cases, this calculation does not provide any meaningful information. For example, there are many companies that will look profitable when you subtract out the interest, taxes, depreciation and amortization. However, in reality, they are actually not very profitable at all. Therefore, this calculation works only with companies that are known to be profitable. When you cannot use a formula uniformly for every company, it starts to lose a little bit of its value. You do not know if the information that it is providing is valuable to you or if you are making an incorrect assumption.

Another problem with the way that people use this calculation is that it is difficult to plan for short-term debt. Many investors like to use this metric to calculate the debt coverage ratio of a company. Yet, this works only when you are dealing with long-term debt. For short-term debt, you are not going to be able to predict it, and it can drastically affect the profitability of a company.

How It Should Be Used

Instead of using EBITDA as a definitive way to determine if a company is profitable, you should most likely use it in conjunction with other valuation multiples. EBITDA can be a good way to determine how much longer a company is going to be able to pay their debt payments without taking on additional financing. This can be valuable information, but it is not going to give you all the information that you need to make an investment decision.

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