Evaluate Company Earnings using EBIT and EBIDTA

EBIT and EBITDA are alternate measures of profitability to net income (or Earnings). These are accounting terms which attempt to represent cash profit generated by the company’s operations.

What are Earnings?

Earnings of a company are simply their net profits, after taking care of the inflow of revenue and all outflow of taxes, interest to be paid out, depreciation of assets etc. Earnings are the truest representation of the net cash generated by the company in a given period.

Earnings in corporate finance = Savings in personal finance.

Alas! The world doesn't remain as simple. We make it complicated in the greed to show "better earnings."

What is EBIT?

Now, it may be possible in personal finance that in certain months you paid interest for some loan you took, or paid taxes on the income you generated (which you always do). In such months, you will naturally have relatively lower savings.

Just the same way happens in corporate finance. If a company takes on debt, it has to pay back the debt with interest. And out of the profits it generates, it has to pay taxes (naturally). 

The interest can vary depending on the type of debt the company takes, prevailing interest rates etc. The taxes can vary depending on the type of products, the geography, and can change with laws and regulations etc.

Since the interest and taxes can vary because of non-business parameters, the earnings may not represent a true parameter to compare the business operations of two different companies.

Here comes our first accounting term: EBIT.

EBIT stands for Earnings Before Interest and Taxes. 

So, if the earnings of a company were Rs. 100 in a period, and it had to pay Rs. 20 in interest as well as Rs. 15 in taxes, then the EBIT of the company would be:

EBIT = Earnings + Interest + Taxes = Rs. 135.

EBIT is also known as Operating Profits. These are the profits truly generated by the company's operations before the profits could be taxed and before the interest was paid out to the lenders.

What is EBITDA?

Taxes and Interest are not the only two scoops that go out of operating profits of the company. There is something called as Depreciation and Amortization which also leak away money from the operating profits.

Company owns assets like machines, vehicles and other tangible infrastructure. The cost of owning this infrastructure is not debited from the company's account in a single year in which these assets were purchased because that would be unfair on the earnings for that specific year. The assets are going to last for many years (and will help the company boost its earnings) and hence the cost of purchase should also be distributed across the years. This distributed cost every year is called as Depreciation.

Depreciation is, therefore, an accounting method used to allocate the cost of a tangible or physical asset over its useful life. 

A company not only owns tangible assets. It also owns many intangible assets e.g., loans. The same accounting practice when applied to intangible assets is termed as Amortization.

Amortization is, therefore, an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time. Concerning a loan, amortization focuses on spreading out loan payments over time. 

When applied to an asset, amortization is similar to depreciation.

So, in any year, a company would have some money being adjusted in the Earnings for Depreciation as well as Amortization.

Here comes EBIDTA.

EBITDA stands for: Earnings Before Interest, Tax, Depreciation and Amortization

EBITDA = Earnings + Interest + Taxes + Depreciation & Amortization

or,

EBITDA = EBIT (Operating Income) + Depreciation & Amortization

Significance of EBIDTA

EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices.

EBITDA is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines.

Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance.

Legendary investors are skeptical.

While the above terms may make lot of accounting sense, these provisions can be misused to showcase something that is surreal.

Veterans pinch their noses whenever a company mentions EBITDA. The legendary Charlie Munger of Berkshire Hathaway once said, "I think that every time you see the word EBITDA, you should substitute the words bullshit earnings." 

Say a company earned Rs 200 crore in revenue and had to spend Rs 80 crore in operating expenses in a quarter. So that means Rs 120 crore of earnings and a margin of 60 per cent! Stellar numbers, indeed.

But are they?

What if the company had taken enormous debt and had to pay Rs 100 crore as interest payments? And what about its assets? Surely, they are not blessed with immortality and will depreciate over time.

This is why investors are not fond of EBITDA as a gauge of profits. While EBITDA can help in the valuation of young companies, it can be guilty of ignoring expenses that are part and parcel of running a business. 

In fact, EBITDA is a non-GAAP (Generally Accepted Accounting Principles) metric, meaning regulatory bodies also view EBITDA in the same light as Charlie Munger.

Adjusted EBIDTA

Now that you know why EBITDA numbers can paint a false narrative, let us introduce you to its infamous cousin, adjusted EBITDA. When EBITDA is not enough to save face, you add back non-recurring costs to your EBITDA, and what you have is adjusted EBITDA.

Adjusted EBIDTA = EBIDTA + Non-Recurring Costs

And what constitutes non-recurring costs? Well, it is everything the company deems non-recurring. There's no framework. From ESOPs (employee stock ownership plan) to marketing expenses, anything can be considered as non-recurring and added back to EBITDA. Neat trick, indeed. To the surprise of none, these non-recurring expenses are rarely non-recurring.

For instance, Paytm reported an adjusted EBITDA of Rs 31 crore. How? It added back ESOP (employee stock ownership plan) expenses to its Rs (-) 326 crore EBITDA. But are ESOPs really non-recurring, given that the company grants them regularly?

And it's not just Paytm. More and more loss-making companies are trying to hide behind this age-old gimmick. Zomato added back ESOPs and losses it incurred in its quick-commerce segment to its EBITDA and reported an adjusted EBITDA (ex. quick commerce) of Rs (-) 38 crores. In reality, its EBITDA was as low as Rs (-) 366 crores.

The adjusted EBITDA metric is most helpful when used in determining the value of a company for transactions such as mergers, and acquisitions - which are truly non-recurring events.

Summary

The more technical a term seems, the more it attracts the so called 'experts'. But a long-term investor just needs basic school education to get rich. So, these technical jargons are better understood, and then ignored for most cases.

In short, read annual reports, keep it simple and stay away from these false narratives. Always remember, the only time a company has to rely on these gimmicks is when the balance sheet is saying a different story. Since the birth of markets as we know them, companies have always come up with ever-innovative ways to hide their losses. As investors, we have to stay vigilant, not follow the hype and also do our due diligence before investing no matter what the social media buzz is saying.

Only in exceptions like a new start up tech company or an asset intensive company, or for rare cases of acquisitions and mergers can these accounting practices make some semblance of sense. 

For all others, these terms merely represent a false narrative.

Regards

Manoj Arora
Official Website