Multipliers for Stock Analysis: Reviewing Ebitda
In our previous articles, we’ve already discussed several market multipliers such as P/S, P/E, ROI, ROE and the ways they are calculated. This time, we’ll get acquainted with another one called Ebitda. Just like other multipliers, Ebitda provides insight into the company’s finances based on its performance.
The Ebitda multiplier – what is it?
Ebitda means “Earnings before interest, taxes, depreciation, and amortization”. Basically, it’s the money earned by a company before all expenses. This multiplier was created way back in the eighties last century and has been used since then because it still appears relevant and can be applied for assessing the financial capabilities of business entities.
Big companies and corporations with massive expenses and assets, which they have been depreciating for a long time, find it very favourable to focus interested parties on the Ebitda coefficient. By doing this, they make their companies more attractive to investors. And vice versa, small companies with minor expenses and assets prefer not to showed their Ebitda multiplier, as it can ruin their investment appeal.
Quite often, Ebitda is coupled with a similar multiplier called Ebit, although they are calculated in different ways. Ebit implies “Earnings before interest and taxes”.
What does Ebitda show?
1. Efficiency of the company’s performance in comparison with its competitors in the industry. Just like many other multipliers, it won’t do any good comparing companies from different sectors.
2. Profitability. Whether there is any use in investing money in this particular company and what profit expectations it offers.
3. Profit expectations for paying expenses, amortization, and taxes. Can the company afford to pay all the above-mentioned and what profit will it have in the end?
Advantages and disadvantages of the Ebitda coefficient (multiplier)
1. It’s more accurate than other multipliers in determining the volume of money due to consideration of amortization.
2. It allows to compare companies with different tax deduction levels, capital structures, and amortization indicators.
3. It offers the opportunity to compare profits before tax and amortization. Based on them, one can draw a conclusion which company is better at optimizing their expenses.
1. There is no single calculation method. Calculations for different companies may vary a lot, hence the comparison is made with unsuspected errors.
2. It doesn’t take into account changes in the company’s working capital, thus leading to an incorrect volume of money, which is usually overestimated.
3. In the case of neglected capital expenses, it misinterprets the company’s actual capabilities to repay its debts.
4. The company’s accounting policy has a direct influence on the Ebitda coefficient.
How Ebitda is calculated
There are two of the most popular methods to calculate Ebitda:
Ebitda top-down = Revenues – Costs of goods (not including amortization) + Operating expenses
- Revenues – the company’s income.
- Costs of goods – costs of materials used for manufacturing, including salaries (amortization expenses are not considered).
- Operating expenses – expenses on transportation and storage of goods, rent of premises, as well as office expenses.
All these indicator values can be taken from the company’s accounting reports.
Ebitda bottom-up = Net income + Interest + Taxes + Amortization
If you calculate the same company using these two different methods, the results will vary significantly. Why? Because of some non-recurring cost items, which makes the difference.
When the Ebitda coefficient value is negative, the company incurs losses even before covering all compulsory payments.
Application of the Ebitda multiplier
Having access to any company’s accounting reports, an investor can easily calculate the Ebitda multiplier. After that, it can be used for comparing companies operating in the same field, even if they are from different countries with different percentage loads.
At the same time, one shouldn’t rely solely on the Ebitda coefficient when assessing the company’s investment appeal. In some cases, a positive value of Ebitda doesn’t say that the company did have net income. The best way to apply the multiplier is to use it as an additional factor when choosing an issuer to invest in.
A low Ebitda value may indicate that the company isn’t doing great and it can’t handle the tax burned and other expenses. If the report doesn’t specify the Ebitda multiplier calculation method, one will have to double-check it on their own or look for confirmation in other sources.
Example of company comparison
Over the previous accounting period, a firm named “ССС“ and a firm called “DDD” both had the same income. However, taxes of “CCC” were 30%, while “DDD” paid only 5% of taxes because of preferential taxation.
At this point, one can draw preliminary conclusions:
If “CCC” switches to preferential taxation, then the income will immediately differ. This simple example shows that “CCC” conducts business more effectively and, in case taxes are reduced and everything else being equal, will make more profit. Consequently, “CCC” is more promising and attractive for investments.
When calculating the Ebitda coefficient, one should navigate traps and pitfalls, that’s why I’ll name two cases when it is okay to rely on this multiplier:
1. When one is well aware of the coefficient calculation method in the company.
2. When one calculates the coefficient on their own.
Despite being quite popular, the Ebitda multiplier is often criticized and many companies, as a rule, don’t show it in their official accounting reports. Nevertheless, many people continue using it for assessing investment appeal.
Lending agencies often use Ebitda to assess a firm’s risks and financial solvency. The best way of applying Ebitda is a comprehensive assessment of the company using several multipliers and other aspects from its accounting reports.