More of this Feature • Introduction • Income Statement • Revenue / sales • Cost of Goods Sold • Gross profit • Gross margin • The first three lines • Operating Expenses • R&D Expense • SG&A Expense • Goodwill Charges • Extraordinary Events • Accounting for extraordinary events • Oper. income/margin • Interest income and expense • Interest coverage ratio • Depreciation expense • Accum. Depreciation • Straight-line Method • Accelerated and Sum of the Years' Digits Method • Dbl Declining Balance • Comparing Depr. Mths • EBITDA • Income taxes • Minority Interests - cost, equity, and consolidated methods • Unreported earnings • Continuing operations • Accounting changes • Preferred dividends • Net income applicable to common shares • Net profit margin • Basic vs. Diluted EPS • Hiding share dilution • Share repurchases • Return on Equity- ROE • Asset turnover • Return on Assets- ROA • Projecting earnings • Formulas & Calculations • Putting it together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • EBITDA Definition - Earnings before interest, tax, depreciation and amortization • Should EBITDA be discarded

Elsewhere on the Web • 10 Critical Failing of EBITDA - Computer World • EBITDA definition • EBITDA: The Good, the Bad, and The Ugly – Investopedia • Ignore EBITDA - The Motley Fool • What is EBITDA - The Motley Fool

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA
EBITDA tells an investor how much money a company would have made if it didn’t have to pay interest on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company’s financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 1980’s during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.

In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don’t exist is the same mentality of the five year old who believes no one can see them when their eyes are closed – while they may enjoy pretending for a while, the IRS and the banks and bondholders who lent money to the company aren’t interested in playing games. When the bills come due, these entities want the money owed to them and can force bankruptcy if they aren’t paid.

Still not convinced? Picture this scenario:

A single man in his mid-twenties, earning $30,000 annually, walks into his local bank to get a loan for a new, top-of-the-line BMW.  Each year, he pays $8,100 in taxes, reducing his monthly check from $2,500 to $1825 [for simplicity sake, let's ignore payroll deductions, etc.]  He currently has a mortgage payment of $1,100 per month, and a student loan payment of $200 per month.  After paying all of these expenses, he has $525 on which to live*.

The loan officer crunches the numbers and comes up with an estimated monthly payment of $750 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. “Sir,” she says, “you only make $525 a month after payments and taxes! You can’t afford this loan. Not only can you not afford the payment, you will then have nothing to live on.” The man looks confused, “but I make $2,500 per month before my payments and taxes.”

See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely aren’t. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.

The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can’t make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn’t be attained, they created a new one that made them appear successful.

In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn’t worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don’t worry about it – four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it’s folly such as this that presents us with opportunity to profit in the market.

If you are interested, there is an excellent article at the Motley Fool’s website called The Limits of EBITDA. I highly recommend it.

*$2,500 monthly pay - $625 taxes - $1,100 mortgage payment - $200 student loan payment = $525 free cash.

Additional information:
10 Critical Failing of EBITDA - Computer World
EBITDA: The Good, the Bad, and The Ugly – Investopedia
Ignore EBITDA - The Motley Fool
What is EBITDA - The Motley Fool
 

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