As a public investor you have probably come across the term EBITDA.  If you haven’t, we guarantee you will see it from at least some of the companies you look at. But what is EBITDA? What does it mean, and how can you use it to ensure you find the right private investments for you?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company’s cash flow from its operating activities.  EBITDA is not a substitute for book earnings under Generally Accepted Accounting Principles, or GAAP. But it can be an important supplement, and professional investors like portfolio managers use EBITDA to compare companies.

ORIGIN

In the 1970’s, John Malone had a problem.  He was building a cable-TV empire but was having trouble borrowing enough money to reach his goals.  The reason is that bank analysts and bond investors saw that his companies were losing money – a lot of money – under GAAP.  Back then, when a company made an acquisition, it amortized much of the purchase price over time.  Malone was also investing money in infrastructure where the financial depreciation was far faster than the useful life of the investments. 

So he created a new metric.  Ignore taxes, he said, since we’re not paying much as a money-losing company. Ignore depreciation and amortization, since that is not cash out the door. Ignore interest, since the whole point is to learn how much interest the company can afford to pay. 

John Malone went on to become a billionaire, and the banks and bond investors who applied EBITDA instead of GAAP earnings all got paid back. 

Calculating EBIDTA

Finding a company’s EBITDA is not that difficult, though you will have to do a little math to do it. Let’s use Intel as an example.  Below is Intel’s earning statement for the first three months of 2022. 

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Intel earned $8.113 billion in the first quarter of 2022. To calculate EBITDA, we are going to add back in interest, taxes, depreciation, and amortization.  Taxes are easy from the earnings above. We add back taxes of $1.548 billion. Interest was $997 million, so we’ll add that back in too. But what about depreciation and amortization?  Some companies will put those figures in their earnings statements, but many more only disclose it in their cash flow statements. So let’s take a look at that. 

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On the cash flow statement, you see depreciation of $2.847 billion and amortization of intangibles of $501 million. Now we have everything we need to calculate EBIDTA.

Adjusted EBITDA

Companies sometimes add back in other expenses to calculate “Adjusted EBITDA.”  In Intel’s example, it might add in that $1.2 restructuring expense, or subtract out the $4.323 billion of gains it made on its equity investments.  Those adjustments can be informative, but always remember that the company is trying to put its best foot forward when they calculate Adjusted EBITDA.  Be cautious and skeptical. 

Using EBITDA

EBITDA cuts through some arcane accounting rules surrounding depreciation and amortization to give a clearer picture of a company’s cash generating ability. But EBITDA should never be used alone. 

Intel’s results are a perfect reason not to use EBITDA alone.  For one thing, there are those restructuring charges and gains.  It might be reasonably to account for those in Adjusted EBITDA; it might not. It depends on how often it happens. If Intel is taking a $1 billion restructuring charge quarter after quarter, then that’s a use of cash you have to consider. If it only takes gains on equity occasionally, you don’t want to count that towards EBITDA. 

You also want to consider other uses of cash. The big one for Intel is capital expenditures. $4.604 of capital expenditures is a big use of cash not considered by EBITDA.  As an investor, you will want to know how much of that expense is to keep Intel’s business going and how much is for future growth. 

This is particularly true for smaller companies like they ones you are likely to see as a private investor. Many companies are investing large amounts of money, more than they generate from their current operations in EBITDA.  You must evaluate how much you believe those expenses will return to the company in the future, and how much money the company must raise from other sources to become a net cash generator. 

EBIDTA as a milestone

Deal Report’s favorite use of EBITDA for private investors is as a company milestone.  In particular, the transition from negative to positive EBITDA is a big event in a company’s life. Positive EBITDA demonstrates that the company’s business plan can generate enough revenue not only to overcome its costs of production but the company’s other cash costs like advertising and personnel. 

Your Checklist Items

Know what EBITDA means when companies talk about it.  Know its uses and its limitations, and be sure to never look at EBITDA alone as a valuation method, only in conjunction with other ways to look at the company. Recognize the transition to positive EBITDA as a huge milestone in a company’s development, but still not a reason for investing without other positive metrics.