EBITDA

We did go over how Leverage Buyouts & Venture Capital investment strategies work and how it benefits the investors, but how do they analyze if the firm that they are investing in, is the right one? Well, one way to do is through calculating and analyzing Earnings Before Interest, Taxes, Depreciation & Amortization, which is EBITDA.

Calculating EBITDA

EBITDA is one of the most frequently used financial metric to analyze a company's performance. It is simply calculated as:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

or

EBITDA = EBIT + Depreciation + Amortization

Components of EBITDA

1. Net income: As the name suggests, it's the net income. Consider you have a room that you purchased at $3,000. You spent some $500 in it's maintenance and another $300 in brokerage. You now sell this room $10,000. Now your net income in this case would be $6,200 ($10,000 - $3,000 - $500 - $300). Simply put subtract all the amount that you invested in that particular item from the total earnings that you made. This is your Net Income.
2. Interest: It is the amount of interest that the firm is paying against the capital/resource borrowed. Every firm has a different Capital Structure that may or may not have debt in place.
3. Taxes: Well, we all know that every firm needs to pay up taxes and this component takes into account any taxes paid.
4. Depreciation: Each company invests in some fixed tangible assets that deteriorate, such as, buildings, equipment etc. These tangible assets have a depreciation value. These are similar to you buying a phone for yourself at $12,000 and then years later, exchanging it at a value of $1,000.
5. Amortization: There may be cases when the firm invests in some intangible assets like trademarks, patents etc. These are valid for a limited period, require renewals and are fixed investments that the firm has to make.

If we observe, we are actually adding back certain expenses that was incurred and then we are adding back any D&A that has been incurred.

Starbucks EBITDA in 2018

We all know Starbucks, let's try and calculate EBITDA for the same using its financial report of 2018:

Image from: WallStreetMojo

Net Income = $4,518 million

Interest = -$170.3 + $191.4 = $21.1 million

Taxes = $1,262 million

D&A = $1,247 million

So, EBITDA = 4518 +21.1 +1262 +1247 = $7,048 million.

Why are we adding back expenses?

This enables analysts and researchers to easily compare and analyze between multiple firms. We are essentially adding back any variable components that may differ between multiple firms, and taking in as a whole asset to compare and contrast the firms.

Does it really give a holistic view?

Although it is a widely used metric, the fact that it doesn't take into account certain expenses incurred or even D&A, it is debated on if it is rather a tool that gives you the whole picture or not? We definitely cannot deny the fact that the firm WILL incur expenses in one form or the other and would also incur D&A.

It can also manage to skew the investors perception as EBITDA will always be higher than the Net Income. Companies with lower income or in high debts can create an illusion through it, well, unless the investors analyze thoroughly.

Does EBITDA adhere to GAAP?

No, EBITDA calculations do not adhere to Generally Accepted Accounting Principles. On mutual discretion, the firms and investors can tweak and modify components to subtract/add certain other expenses as well.

Even after all the limitations, this metric is used widely as it definitely does provide an easy way to analyze between different firms. It is thus suggested to use it in conjunction with other metrics to achieve the highest value.