About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
EBITDA: How to Calculate EBITDA and Advantages and Disadvantages
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a proxy for a company’s core, recurring business cash flow from operations before the impact of capital structure, taxes, and re-investment.
EBITDA Definition: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a proxy for a company’s core, recurring business cash flow from operations before the impact of capital structure, taxes, and re-investment.
One interpretation of EBITDA, courtesy of Paulie from The Sopranos, is as follows:
To calculate EBITDA, start with Operating Income or EBIT on the Income Statement and then add the Depreciation & Amortization (D&A) from the Cash Flow Statement.
You add back D&A because it represents the allocation of spending on long-term assets (factories, buildings, IP, etc.) from previous periods.
In other words, the company has already spent money on the items represented by D&A, so they do not represent cash outflows in the current period.
You must use the D&A number shown on the Cash Flow Statement – if not, you might not capture the full amount.
Many companies do not list the full D&A expense on their Income Statements, or they embed it within other expenses there.
To calculate EBITDA for a company like Target, we would follow this approach and take the Operating Income on the Income Statement and add D&A on the Cash Flow Statement:
If you have additional time and resources and want to go beyond this, you could also look for non-recurring expenses in the financial statements and add these to calculate EBITDA.
In this case, Target does not appear to have any immediately obvious non-recurring expenses that affect its Operating Income, but it may have some embedded within its line items if we review the filings in more detail.
On the other hand, a company like Steel Dynamics has an obvious non-recurring charge we should add back when calculating EBITDA in one of its historical Income Statements:
People often criticize EBITDA because it differs from Cash Flow from Operations – even though it is supposed to be a proxy for “recurring business cash flow from operations.”
This is a fair criticism, but it misses the point because the true purpose of EBITDA is to compare companies quickly and simply.
If you want estimates of their “true cash flows,” you must adjust the standard EBITDA calculation or use alternate metrics (see below).
Files & Resources:
EBITDA and Cash Flow from Operations for Target and Best Buy (XL)
EBITDA – Slide Presentation (PDF)
Best Buy – 10-K Extracts (PDF)
Video Table of Contents:
0:00: Introduction
4:56: Part 1: How to Calculate EBITDA in More Detail
7:06: Part 2: What Does EBITDA Mean?
8:41: Part 3: Is EBITDA Close to Cash Flow from Operations?
10:16: Part 4: The Pros and Cons of EBITDA
11:11: Recap and Summary
How to Calculate EBITDA in More Detail
First, note that when calculating EBITDA, you should only add back non-recurring expenses – not non-cash expenses.
For example, Stock-Based Compensation is a non-cash expense, but it is clearly recurring for most companies, and, unlike D&A, it affects the company’s share count.
Therefore, you should not add it back to EBITDA.
Adding back D&A is justified because it represents a simple timing difference, not a changed share count or capital structure.
Also, you should add back items only if they have affected Operating Income, which explains why Gains and Losses are not part of the adjustments.
Yes, they are non-recurring, but they normally appear within “Other Income / (Expenses)” on the Income Statement, which is below the Operating Income line.
Finally, be careful with “allegedly non-recurring expenses that are actually recurring,” such as Restructuring for many companies.
For example, Best Buy lists “Restructuring” as a separate line on its statements, but is it truly non-recurring? We’d say “no” because it appears in 3 out of the 3 past years:
What Does EBITDA Mean?
EBITDA is a way to compare the core cash flows of different companies while ignoring their capital structure, tax, and re-investment differences.
Sometimes, you want to do this, such as in benchmarking analysis or a quick screen for comparable public companies.
But in other cases, you want to do the opposite and reflect these differences to capture the company’s true cash flows and ability to service debt, make acquisitions, and return capital to shareholders.
EBITDA can tell you whether the company’s core business is growing, declining, or becoming more/less profitable – and what drives these changes.
It’s most meaningful when you’re looking at similarly sized companies in the same industry and benchmarking their profitability or ability to service Debt.
For example, we can compare EBITDA for Target and Best Buy:
Target has slightly higher margins, indicating greater efficiency, but it also has less capacity to issue new debt since it already has a substantial balance with significant interest each year.
You can assess this via metrics such as Debt / EBITDA and EBITDA / Interest, which are used in debt vs. equity analysis.
You can also create valuation multiples based on EBITDA, such as the Enterprise Value / EBITDA or TEV / EBITDA multiple (see our EBIT vs. EBITDA vs. Net Income comparison article).
Is EBITDA Close to a Company’s Cash Flow from Operations?
Famous investors like Warren Buffet have criticized EBITDA for excluding Capital Expenditures and other line items that significantly impact a company’s cash flows.
And they’re correct!
Even if you ignore the CapEx issue and focus on Cash Flow from Operations (CFO) rather than Free Cash Flow, since CFO also ignores CapEx, EBITDA is rarely close to CFO:
While EBITDA and CFO are similar because both metrics deduct COGS and Operating Expenses and add back D&A, there are also many differences:
-The Change in Working Capital can be significant for retail/manufacturing companies.
-The lack of subtraction for Taxes within EBITDA is another huge difference.
-The Interest Expense also makes a difference for any company with significant Debt.
How to Make EBITDA More Accurate
If you want to bring EBITDA closer to Cash Flow from Operations or Free Cash Flow, you can use a variant such as EBITDA – CapEx or EBITDA – CapEx +/- Change in Working capital:
You could even deduct the Cash Taxes (i.e., Book Taxes minus the Deferred Tax component on the CFS).
However, the more adjustments you make, the less useful EBITDA is as a quick and simple comparison metric.
So, if you want accurate cash flows, consider metrics such as Free Cash Flow or Unlevered Free Cash Flow instead.
The Final Word on EBITDA: Pros and Cons
EBITDA is just a tool; like any tool, it has good and poor uses.
People who criticize it for its shortcomings have a point, but in most cases, they do not understand its true purpose.
EBITDA is quick and simple to calculate, lets you easily compare companies, and is universally known in finance.
On the other hand, even though it purports to be a “proxy for cash flow” (with many adjustments), it is not close to Cash Flow from Operations or Free Cash Flow in most cases.
And unlike what Paulie stated in The Sopranos, it’s not exactly “the true picture of a company’s profitability.”
It’s closer to “the true picture of a company’s cash flows, ignoring its taxes, capital structure, and business re-investment requirements.”
If you squint, you could argue this definition still represents profitability, but it’s a bit of a stretch.
That said, The Sopranos was right about one thing: If you don’t even know your EBITDA, do not sell your business!
While it may not be the be-all-end-all for valuation, it is still very important when valuing companies and pricing deals.
