Every now and then, investors can slip into using jargon. That can make certain aspects of investing seem more difficult than they need to be. In this article, we’re going to take a look at the term EBITDA which is an acronym that frequently gets used as a word similar to FOMO and YOLO.
In this case, EBITDA is one of the most important terms to understand when analyzing if a stock is a good buy. The good news is that it’s really to understand. And in case you’re wondering, you won’t have to do any math. All of that is done for you.
So without further ado, here’s a brief explanation of the term EBITDA including why it matters to investors.
What Does EBITDA Stand For?
EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. As an accounting term, EBITDA is one of the key metrics that determine how much tax a company pays. But since I promised that you wouldn’t have to do math, what you need to understand is that EBITDA gives investors a good idea of how profitable a company is from its core business activity. EBITDA strips out items on a company’s balance sheet that doesn’t really impact business activity, such as:
Interest: This includes loan interest and earnings from a company’s shares. These largely depend on the internal financial strategy of a company and don’t have to do with the core activities of the business.
Taxes: The taxes that a company pays depend on outside factors that don’t accurately reflect how profitable a company’s activities are.
Depreciation: Normal depreciation on tangible assets and immaterial goods results from investments that a company makes. Once again, it doesn’t have a meaningful impact on a company’s profitability.
Amortization: This is the action or process of gradually writing off the initial cost of an asset. Whereas depreciation typically refers to tangible assets; amortization typically refers to intangible assets (e.g. patents and copyrights).
Why is EBITDA Important?
Along with a company’s EBITDA a company will often give its EBITDA margin. This is EBITDA divided by a company’s revenue. The EBITDA margin is a ratio that shows a company’s operating profitability. This means, in general, the higher the EBITDA margin the more attractive a company looks.
How is EBITDA Different From Net Income?
Net income is the amount of profit or loss (i.e. money) that a company has left after all of its operating expenses are covered (e.g. cost of goods sold, salary) as well as all the items covered by EBITDA. Therefore, proponents of EBITDA say that it keeps a clearer view of the health of a company’s core business.
How is EBITDA Different from Earnings Per Share (EPS)?
Earnings per share (EPS) is calculated by dividing a company’s net income and dividing it by the number of outstanding shares of common stock. EPS is a measure of how much of a company’s income would be available for every shareholder. A higher EPS generally means that a company is doing well. As a company matures, it may begin to pay out a portion of its profits as a dividend. In this case, the company will strip the money it sets aside for dividends from net income before calculating EPS.
What is a Good EBITDA?
There’s no clear answer to that. However, if you understand how EBITDA is different from net income and EPS it can help you an idea into the financial health of a company.
For example, a company may be profitable from its operations. However, if a significant portion of that revenue is being taken up by high taxes, interest payments or depreciation, it will have less money available for shareholders. This is why rising interest rates are generally seen as negative for a company’s profit. The rising cost of borrowing goes straight to the company’s bottom line.
The combination of a high EBITDA and a low EPS is another way for investors to identify a company that may not have cash available to pass along to shareholders and/or to grow their business.
Limitations of EBITDA
There are two significant limitations of EBITDA are. First it’s not a substitute for cash flow. Businesses frequently have capital expenditures (capex) and it’s critical that investors consider those expenses when looking at a company’s finances. Typically a company will provide estimates of its anticipated capex expenses when they deliver their quarterly earnings reports.
In the dot-com era of the late 1990s and early 2000s, many unprofitable companies used EBITDA to appear as if they were financially healthy. And even today, EBITDA is frequently used for public companies that have yet to turn a profit.
Second, the EBITDA ratio can vary from sector to sector. For example, the online retail sector is likely to have a higher EBITDA ratio than a less volatile sector like utilities.
Some Final Thoughts on EBITDA
As this article explains, EBITDA is all about profit and specifically the profit that a company has after it accounts for a range of other expenses.
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