EBITDA: Definition, Calculation Formulas, History, and Criticisms (2024)

History of EBITDA

EBITDA is the invention of one of the very few investors with a record rivaling Buffett's: Liberty Media Chairman John Malone. 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.

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 that was expected 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.

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.

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

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.

Criticisms 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 heavilyor are experiencing rising capital and development costs. In those cases, EBITDA may serve to distract investors from the company's challenges.

These are among the other criticisms of EBITDA:

EBITDA Ignores Asset Costs

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?"

Earnings Figures May Be Suspect

While the formulas for calculating EBITDA may seem simple enough, different companies use different earnings figures as the starting point. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement.

Company Valuation Can Be Obscured

All the cost exclusions in EBITDA can make a company appear 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 didn't mean that the company was a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much-higher 20 times, and 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.

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. EBIT vs. EBT

Earningsbeforeinterest andtaxes (EBIT) is a company's net income plus income taxand interest expenses.EBIT is used to analyze the profitability of a company's core operations. The following formula is used to calculate EBIT:

$\begin{aligned}\text{EBIT}=\text{Net Income}+\text{Interest Expense}+\text{Tax Expense}\end{aligned}$EBIT=NetIncome+InterestExpense+TaxExpense​

Since net income includes interest and tax expenses, to calculate EBIT, these deductions from net income must be reversed.

Earnings before tax (EBT) reflects how muchof an operating profithas been realized before accounting for taxes, while EBITexcludes both taxes and interest payments. EBTis calculated by adding just tax expense to the company's net income.

By excludingtax 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 companiesthat might be subject to different state tax rates or federal tax rules.

Unlike EBITDA, EBT andEBIT do include the non-cash expenses of depreciation and amortization.

EBITDA vs. Operating Cash Flow

Operating cash flowis a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income while also including changes inworking 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 can miss clues—for example, difficulties with receivables collection—that may impair cash flow.

The Bottom Line

EBITDA can be 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 EBITDA's abuse by unscrupulous corporate managers. The best defense for investors against such practices is to read the fine print reconciling the reported EBITDA to net income.

Correction—April 30, 2023. An earlier version of this article contained an arithmetic error in the calculation of EBITDA. The expected taxes were $5 million, not $4 million.