What is EBITDA ? EBITDA stands for “earnings before interest, taxes, depreciation and amortization” and it looks at the cash an underlying business can make

EBITDA , or “earnings before interest, taxes, depreciation and amortization.” came into common use in the 1980s. At the time, high interest rates and high inflation forced many big companies to the verge of insolvency. When that happens, companies have to restructure their finances and operations or risk going bankrupt. They may need to pay off their current loans and bonds, because they no longer qualify for the low rates offered under the terms of earlier financing. This means they have to find new, higher-cost financing with new lenders who accept higher-risk borrowers and charge higher interest rates. They may also sell or shut down parts of their operations that are losing money and draining their cash.

In a situation like this, bankers and other lenders need to decide how much debt the company can service, at the new, higher interest rates it will have to pay after the restructuring. To do that, you have to look at how much cash the underlying businesses can generate, and EBITDA does just that. But what is EBITDA in detail, and why can it be problematic?

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What is EBITDA ? 4 facts to know

• EBITDA ignores interest expense, since this expense largely depends on how the management chooses to finance the company. If it runs on borrowed money, its interest expense will be high. If it instead raises money through the sale of shares (or the sale of assets), interest expense shrinks or disappears.
• EBITDA leaves out taxes because they can vary widely, depending on prior years’ acquisitions and losses. This distorts the income that the underlying business can generate to service debt.
• EBITDA leaves out deductions for depreciation and amortization. These charges may reflect arbitrary and/or subjective judgments about how long the company will be able to use its equipment and other assets, and what those assets would bring if sold.
• EBITDA is rarely an issue with the kind of well-established, soundly financed, conservative companies we focus on in our recommendations. It gets to be an issue with companies that have chosen to finance themselves with high levels of debt.

What is EBITDA good for?

EBITDAs can be helpful when comparing two companies—in a sense, it compares the ability of a company’s managers to make money when debt structure and so on are identical.

EBITDA is often used as a valuation measure in mergers and acquisitions, especially when small businesses or mid-sized companies are involved. Mergers are when two or more companies combine to form one entity. An acquisition is when a company buys another one.

What is EBITDA limited by?

Excess debt and interest costs can hurt a company’s earnings and cash flow, and investors need to be aware of that—and factor it into their investment decisions.

Because of its limitations, EBITDA is not compatible with the rules of generally accepted accounting principles.

In terms of financial performance, we recommend looking beyond EBITDA for stocks with a long-term record of dividends, a long-term record of profit, an attractive balance sheet, industry prominence or dominance, and the ability to serve all shareholders.

Bonus Tip: Instead of EBITDA, keep long-term conservative investing goals in view

In our view, your goal as an investor, particularly if you follow a conservative investing strategy like the one we recommend, is to make an attractive return on your investments over a period of years or decades. Failure means making bad investments that leave you with meagre profits or, even, losses.

Unsuccessful investors can still make some profits. They just don’t make enough to offset the inevitable losses and leave themselves with an attractive return. If you focus on the idea that you never go broke taking a profit, you may be tempted to sell your best investments whenever it seems the investment outlook is clouding over.

On occasion, you may succeed in selling just prior to a major downturn, and buying back at much lower prices. More often, prices will soon hit bottom and move up to new highs. If you buy back, you’ll pay higher prices. If you had followed this strategy with Canadian bank stocks, for example, you could have missed out on some big gains over the years.

In hindsight, market downturns are easy to spot. Spotting them ahead of time is much harder, and impossible to do consistently. After all, if you could consistently spot market downturns ahead of time, you could acquire a large proportion of all the money in the world, and nobody ever does that.

The problem is that you’ll foresee a lot of market downturns that never occur. All too often, the market-downturn clouds disperse soon after skittish investors have sold. Good reasons to sell do crop up from time to time, of course, even if you follow a long-term conservative investing approach, but “You’ll never go broke taking a profit” is not one of them.

What has your experience been with investing in companies that have high debt?

If you have used EBITDA as an investment decision-making tool, how has it helped you?