1/24/23, 2:16 PM EBITDA: Meaning, Formula, and History

CORPORATE FINANCE ACCOUNTING

EBITDA: Meaning, Formula, and History

By ADAM HAYES Updated August 10, 2022

Reviewed by THOMAS BROCK

Investopedia / Zoe Hansen

What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an
alternate measure of profitability to net income. By stripping out the non-cash
depreciation and amortization expense as well as taxes and debt costs
dependent on the capital structure, EBITDA attempts to represent cash profit
generated by the company’s operations.

EBITDA is not a metric recognized under generally accepted accounting

principles (GAAP). Some public companies report EBITDA in their quarterly
results along with adjusted EBITDA figures typically excluding additional costs,
such as stock-based compensation.

Increased focus on EBITDA by companies and investors has prompted claims

that it overstates profitability. The U.S. Securities and Exchange Commission
(SEC) requires listed companies reporting EBITDA figures to show how they
were derived from net income, and it bars them from reporting EBITDA on a
per-share basis. [1]

KEY TAKEAWAYS
Earnings before interest, taxes, depreciation, and amortization
(EBITDA) is a widely used measure of core corporate profitability.
EBITDA is calculated by adding interest, tax, depreciation, and
amortization expenses to net income.
EBITDA lets investors assess corporate profitability net of expenses
dependent on financing decisions, tax strategy, and discretionary
depreciation schedules.
Some, including Warren Buffett, call EBITDA meaningless because it
omits capital costs.

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The U.S. Securities and Exchange Commission (SEC) requires listed
companies to reconcile any EBITDA figures they report with net income
and bars them from reporting EBITDA per share.

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EBITDA

EBITDA Formulas and Calculation

If a company doesn’t report EBITDA, it can be easily calculated from its financial
statements.

The earnings (net income), tax, and interest figures are found on the income
statement, while the depreciation and amortization figures are normally found
in the notes to operating profit or on the cash flow statement. The usual
shortcut for calculating EBITDA is to start with operating profit, also
called earnings before interest and taxes (EBIT), then add back depreciation
and amortization.

There are two distinct EBITDA formulas, one based on net income and the other
on operating income. The respective EBITDA formulas are:

EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization

and

EBITDA = Operating Income + Depreciation & Amortization

Understanding EBITDA
EBITDA is net income (earnings) with interest, taxes, depreciation, and
amortization added back. EBITDA can be used to track and compare the
underlying profitability of companies regardless of their depreciation
assumptions or financing choices.

Like earnings, EBITDA is often used in valuation ratios, notably in combination

with enterprise value as EV/EBITDA, also known as the enterprise multiple.

EBITDA is especially widely used in the analysis of asset-intensive industries

with a lot of property, plant, and equipment and correspondingly high non-cash
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
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technology and research companies use EBITDA when discussing their
performance. [2]

Annual changes in tax liabilities and assets that must be reflected on the
income statement may not relate to operational performance. Interest costs
depend on debt levels, interest rates, and management preferences regarding
debt vs. equity financing. Excluding all these items keeps the focus on the cash
profits generated by the company’s business.

Of course, not everyone agrees. “References to EBITDA make us shudder,”

Berkshire Hathaway Inc. (BRK.A) CEO Warren Buffett has written. According to
Buffett, depreciation is a real cost that can’t be ignored and EBITDA is not “a
meaningful measure of performance.” [3]

Example of EBITDA
A company generates $100 million in revenue and incurs $40 million in cost of
goods sold and another $20 million in overhead. Depreciation and amortization
expenses total $10 million, yielding an operating profit of $30 million. Interest
expense is $5 million, leaving earnings before taxes of $25 million. With a
20% tax rate and interest expense tax deductible, net income equals $21 million
after $4 million in taxes is subtracted from pretax income. If depreciation,
amortization, interest, and taxes are added back to net income, EBITDA equals
$40 million.

Net Income $21,000,000

Depreciation Amortization +$10,000,000

Interest Expense +$5,000,000

Taxes +$4,000,000

EBITDA $40,000,000

History of EBITDA
EBITDA is the invention of one of the very few investors with a record rivaling
Buffett’s: Liberty Media Chair John Malone. [4] The cable industry pioneer came
up with the metric in the 1970s to help sell lenders and investors on his
leveraged growth strategy, which deployed debt and reinvested profits to
minimize taxes. [5] [6]

During the 1980s, the investors and lenders involved in leveraged buyouts
(LBOs) found EBITDA useful in estimating whether the targeted companies had
the profitability to service the debt likely to be incurred in the acquisition. Since
a buyout would likely entail a change in the capital structure and tax liabilities,
it made sense to exclude the interest and tax expense from earnings. As non-
cash costs, depreciation and amortization expense would not affect the
company’s ability to service that debt, at least in the near term. [7]

The LBO buyers tended to target companies with minimal or modest near-term
capital spending plans, while their own need to secure financing for the
acquisitions led them to focus on the EBITDA-to-interest coverage ratio, which
weighs core operating profitability as represented by EBITDA against debt
service costs. [7]

EBITDA gained notoriety during the dotcom bubble, when some companies
used it to exaggerate their financial performance. [8]

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The metric received more bad publicity in 2018 after WeWork Companies Inc., a
provider of shared office space, filed a prospectus for its initial public offering
(IPO) defining its “Community Adjusted EBITDA” as excluding general and
administrative as well as sales and marketing expenses. [9] [10]

Drawbacks of EBITDA
Because EBITDA is a non-GAAP measure, the way it is calculated can vary from
one company to the next. It is not uncommon for companies to emphasize
EBITDA over net income because the former makes them look better.

An important red flag for investors is when a company that hasn’t reported
EBITDA in the past starts to feature it prominently in results. This can happen
when companies have borrowed heavily or are experiencing rising capital and
development costs. In those cases, EBITDA may serve to distract investors from
the company’s challenges.

Ignores Costs of Assets

A common misconception is that EBITDA represents cash earnings. However,
unlike free cash flow, EBITDA ignores the cost of assets. One of the most
common criticisms of EBITDA is that it assumes profitability is a function of
sales and operations alone—almost as if the company’s assets and debt
financing were a gift. To quote Buffett again, “Does management think the
tooth fairy pays for capital expenditures?” [11]

What Defines Earnings?

While subtracting interest payments, tax charges, depreciation, and
amortization from earnings may seem simple enough, different companies use
different earnings figures as the starting point for EBITDA. In other words,
EBITDA is susceptible to the earnings accounting games found on the income
statement. Even if we account for the distortions that result from excluding
interest, taxation, depreciation, and amortization costs, the earnings figure in
EBITDA may still prove unreliable.

Obscures Company Valuation

All the cost exclusions in EBITDA can make a company look much less expensive
than it really is. When analysts look at stock price multiples of EBITDA rather
than at bottom-line earnings, they produce lower multiples.

Consider the historical example of wireless telecom operator Sprint Nextel. On

April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might
sound like a low multiple, but it doesn’t mean that the company is a bargain. As
a multiple of forecast operating profits, Sprint Nextel traded at a much-higher
20 times. The company traded at 48 times its estimated net income.

“There’s been some real sloppiness in accounting, and this move toward using
adjusted EBITDA and adjusted earnings has produced some companies that I
think are trading on valuations that are not supported by the real
numbers,” hedge fund manager Daniel Loeb said in 2015. [12]

Not much has changed on that front since then. Investors using solely EBITDA
to assess a company’s value or results risk getting the wrong answer.

EBITDA vs. EBT and EBIT

Earnings before interest and taxes (EBIT), as mentioned earlier, is a company’s
net income excluding income tax expense and interest expense. EBIT is used to

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1/24/23, 2:16 PM EBITDA: Meaning, Formula, and History
analyze the profitability of a company’s core operations. The following formula
is used to calculate EBIT: 

EBIT = Net Income + Interest Expense + Ta

Since net income includes interest and tax expenses, to calculate EBIT, these
deductions from net income must be reversed. EBIT is often mistaken for
operating income since both exclude tax and interest costs. However, EBIT may
include nonoperating income while operating income does not.

Earnings before tax (EBT) reflects how much of an operating profit has been
realized before accounting for taxes, while EBIT excludes both taxes and
interest payments. EBT is calculated by adding tax expense to the company’s
net income.

By excluding tax liabilities, investors can use EBT to evaluate performance after

eliminating a variable typically not within the company’s control. In the United
States, this is most useful for comparing companies that might be subject to
different state rates of federal tax rules.

EBT and EBIT do include the non-cash expenses of depreciation and

amortization, which EBITDA leaves out.

EBITDA vs. Operating Cash Flow

Operating cash flow is a better measure of how much cash a company is
generating because it adds non-cash charges (depreciation and amortization)
back to net income but also includes changes in working capital, including
receivables, payables, and inventory, that use or provide cash.

Working capital trends are an important consideration in determining how

much cash a company is generating. If investors don’t include working capital
changes in their analysis and rely solely on EBITDA, they may miss clues—for
example, such as difficulties with receivables collection—that may impair cash
flow.

How do you calculate earnings before interest, taxes,

depreciation, and amortization (EBITDA)?
You can calculate earnings before interest, taxes, depreciation, and
amortization (EBITDA) by using the information from a company’s income
statement, cash flow statement, and balance sheet. The formula is as follows:

EBITDA = Net Income + Interest + Taxes + Depreciation & Amortization

What is a good EBITDA?

EBITDA is a measure of a company’s profitability, so higher is generally better.
From an investor’s point of view, a “good” EBITDA is one that provides
additional perspective on a company’s performance without making anyone
forget that the metric excludes cash outlays for interest and taxes as well as the
eventual cost of replacing its tangible assets.

What is amortization in EBITDA?

As it relates to EBITDA, amortization is the gradual discounting of the book
value of a company’s intangible assets. Amortization is reported on a company’s
income statement. Intangible assets include intellectual property such as

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patents or trademarks as well as goodwill, the difference between the cost of
past acquisitions and their fair market value when purchased.
The Bottom Line
EBITDA is a useful tool for comparing companies subject to disparate tax
treatments and capital costs, or analyzing them in situations where these are
likely to change. It also omits non-cash depreciation costs that may not
accurately represent future capital spending requirements. At the same time,
excluding some costs while including others has opened the door to the
metric’s abuse by unscrupulous corporate managers. The best defense against
such practices is to read the fine print reconciling the reported EBITDA to net
income.

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Related Terms
EDITDAR: Meaning, Formula & Calculations, Example,
Pros/Cons
EBITDAR—an acronym for earnings before interest, taxes, depreciation, amortization, and
restructuring or rent costs—is a non-GAAP measure of a company's financial
performance. more

Operating Income
Operating income is a company's profit after deducting operating expenses such as
wages, depreciation, and cost of goods sold. more

Operating Profit: How to Calculate, What It Tells You,

Example
Operating profit is the total earnings from a company's core business operations,
excluding deductions of interest and tax. more

Operating Income Before Depreciation and Amortization

(OIBDA)
Operating Income Before Depreciation and Amortization (OIBDA) shows a company's
profitability in its core business operations. more

Adjusted EBITDA: Definition, Formula and How to Calculate

Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) is a
measure computed for a company that takes its earnings and adds back interest
expenses, taxes, and depreciation charges, plus other adjustments to the metric. more

Earnings Before Interest and Taxes (EBIT): How to Calculate

with Example
Earnings before interest and taxes (EBIT) is an indicator of a company's profitability and is
calculated as revenue minus expenses, excluding taxes and interest. more

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