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Investors use a variety of metrics to help them analyze a company's profitability. One of them is EBITDA, an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This metric helps investors evaluate a company's operating performance by adjusting for the impact of balance sheet financing, accounting charges, and income taxes.
What is EBITDA?
EBITDA is a profitability metric that shows a company's underlying earnings before the impact of the following accounting deductions:
- Interest: The cash expense during the reporting period on a company's debt.
- Taxes: The cash expense during the reporting period for taxes owed on income.
- Depreciation: A non-cash charge against earnings due to the gradual reduction in the value of a tangible asset on a company's balance sheet.
- Amortization: A non-cash charge against the value of an intangible asset on a company's balance sheet.
Companies highlight EBITDA as a key earnings metric primarily in industries where accounting deductions have a significant impact on operating income. For example, businesses that use a lot of debt to fund their operations or record large depreciation charges against the value of their assets. By removing these accounting deductions, investors can see how much income the business generates after adjusting for its balance sheet capital structure or the capital intensity of its industry.
Investors also use EBITDA to make other calculations to help them analyze and compare companies. For example, EBITDA is a crucial input for metrics that measure valuation, leverage, and profitability.
How to calculate EBITDA using an EBITDA formula
Many companies report EBITDA as part of their quarterly financial statement. However, it's easy to calculate this earnings metric if it's not readily accessible. Here are several formulas used for calculating EBITDA:
- EBITDA = Earnings before interest and taxes (EBIT) + Depreciation expense + Amortization expense
- EBITDA = Total Revenue - Cost of Goods Sold
- EBITDA = Net income + Income tax + Interest expense + Depreciation expense + Amortization expense
What are the pros and cons of using EBITDA to understand profitability?
EBITDA has become an important profitability metric for several reasons, including:
- It can provide a clearer picture of a company's underlying income and profit growth trends.
- It can be a good proxy for whether a company is generating enough cash earnings to cover operating expenses.
- It's useful for analyzing and comparing profitability, business valuation, and leverage.
While EBITDA is a widely used earnings metric, it also has its share of drawbacks, including:
- EBITDA is a non-GAAP accounting measure, which means it can vary significantly from one company to another.
- Putting too much emphasis on EBITDA can cause investors to overlook a company's actual financial performance.
- EBITDA ignores key financial inputs, like the cost of assets and working capital.
- EBITDA adjusts for cash expenses like income tax and interest expense, which means it's not a good proxy for free cash flow.
Because EBITDA isn't a perfect profitability measurement, investors shouldn't solely rely on it as their basis for making an investment decision.
How EBITDA is useful to real estate investors
Companies in many industries use EBITDA, including the real estate sector. Real estate investment trusts (REITs) in particular use non-GAAP metrics like EBITDA to help investors understand their underlying earnings because interest payments on their debt, as well as depreciation charges, can significantly impact reported net income.
While most REITs favor the use of FFO as their earnings metric of choice, some sub-sectors also highlight their EBITDA, especially if they generate significant non-rental income. Examples include REITs focused on owning data centers, infrastructure, timberland, and hotels. These REITs provide EBITDA as a supplemental earnings metric so investors can see the impact that interest expenses and depreciation charges have on their net earnings.
When should real estate investors use EBITDA?
In addition to using a company's EBITDA as an earnings metric, real estate investors can also perform various calculations with this number to analyze a company's underlying performance, leverage, and valuation.
For example, hotel REITs report a variety of EBITDA-based metrics, such as Hotel EBITDA per Key and Hotel EBITDA Margin. These numbers enable a hotel REIT to gauge the underlying profitability of its properties so that they know which ones need to improve.
Another important use of EBITDA for real estate investors is as a leverage metric. Investors use a debt-to-EBITDA ratio to measure how much debt a REIT has compared to its underlying earnings as measured by EBITDA. When this ratio rises above a certain level -- usually more than 6.0 times for a REIT -- it can signify that the company has too much debt.
Finally, some REIT investors use an EBITDA multiple for measuring valuations, such as enterprise value to EBITDA. That's because it adjusts for the impact of a company's debt, which can provide a more accurate picture of its underlying valuation compared to a similar company.
An example of EBITDA in action
As mentioned, some REITs report EBITDA or a variation like adjusted EBITDA to show investors a more accurate picture of their earnings. For example, a REIT recorded a net loss of $14 million during its most recent reporting period. However, that didn't truly reflect its operating performance during the period, which is why it also reported EBITDA. According to the company's income statement, it paid $89 million of interest expenses, $1 million of income taxes, and recorded $128 million of depreciation and amortization charges. Thus, the REIT would have reported $204 million of EBITDA during the period (-14 + 89 + 1 + 128 = 204). By doing an EBITDA calculation, investors can see that although REIT didn't report a net profit, it isn't losing money.
EBITDA is an important metric for an investor's toolbox
EBITDA helps investors cut through some of the issues that can have an outsized impact on reported net earnings in specific market sectors like real estate. Because of that, it's an important metric for investors to understand so they can use it wisely when analyzing companies. However, it's not a perfect measure of a company's profit, which is why investors shouldn't solely rely on EBITDA. Instead, they should use it in conjunction with other metrics to have a fuller picture of a company's financial health.
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