Earnings Yield of the Enterprise

EBIT multiple  = EV / EBIT

Earnings Yield of the Enterprise (before tax)  EY = EBIT / EV

For example:
EY of A = 11.3%
EY of B = 15.3%

The EY of B at 15.3% is higher than the 11.3% of A, hence, B is a cheaper buy than A.

The EY computation is pre-tax EY and this is good enough for comparison among companies.  

For determining if you would like to invest in a stock, use after-tax EY so that you can compare with other alternative investments.


EY (after tax) = (EBIT x (1 - tax rate) / EV

For example:
EY (after tax) of A = 8.5%
EY (after tax) of B = 11.5%



Why is the earnings yield so important?

1.  It allows you to see how cheap a stock currently is.  Unlike a DCF analysis, calculating a stock's current earnings yield requires no estimates into the future.

2.  Using earnings yield as your main valuation tool to compare the relative price-value relationship of companies in the same industry, helps you to see which one is a better buy.. For individual cases, the investor should be happy to invest in a company with normal growth rate of 5% with an after-tax earnings yield of 12%.



How to use EV / EBIT?

1)  EV / EBIT as a primary tool to

• evaluate its earnings power and
• to compare it to other companies, 

in addition to the PE ratio.


2)  Joel Greenblatt uses for his Magic Formula the Earnings Yield of the enterprise, in conjunction with the Return on Invested Capital (ROIC).

3)  Buffett uses this when evaluating a business and has said that he will generally be willing to pay 7 x EV / EBIT for a good business that is growing 8% - 10% per year


4)  For cyclical plantation companies which have a lot of debts, it is more appropriate to use EBIT multiple and EV per hectare, rather than basing on PE ratio and market cap per hectare.


Summary

EBIT multiples (EV / EBIT) are better market valuation metrics than PE. 

However, both EBIT multiples and PE are all relative and comparative metrics.. 

It would be better if we can determine the absolute value of a stock, the intrinsic value. 

We can then compare the market price with the intrinsic value and determine the margin of safety to give us a better decision making in stock investment.



Reference::

Pages 251 - 252
The Complete VALUE INVESTING Guide that Works!  by K C Chong

EBITDA Analysis Obscures the Difference between Good and Bad Businesses

EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow.

Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business.


Service Company X
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 0
___________________________
EBIT  $20
___________________________
EBITDA $20



Manufacturing Company Y
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 20
____________________________
EBIT  $0
____________________________
EBITDA $20



Investors relying on EBITDA as their only analytical tool would value these two businesses equally.

At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing.

Although these businesses have identical EBITDA, they are clearly not equally valuable. 

• Company X could be a service business that owns no depreciable assets.   
• Company Y could be a manufacturing business in a competitive industry.

Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery.   It has no free cash flow over time.

• Anyone who purchased Company Y on a leveraged basis would be in trouble.  
• To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when the plant and equipment needed to be replaced. 
• Company Y would eventually go bankrupt, unable both to service its debt and maintain its business.  

Company X, by contrast, has no capital-spending requirements and thus has substantial cumulative free cash flow over time.

• Company X, by contrast, might be an attractive buyout candidate.

The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.

EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

Investors in public companies have historically evaluated them on reported earnings.

By contrast, private buyers of entire companies have valued them on free cash flow.



Historical

In the latter half of the 1980s, entire businesses were bought and sold almost as readily as securities, and it was not unreasonable for investors in securities to start thinking more like buyers and sellers of entire businesses.

In a radical departure from the historical norm, many stock and junk-bond buyers in the latter half of the 1980s replaced earnings with cash flow as the analytical measure of value.

In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number, that would quantify a company's cash-generating ability.  The cash-flow calculation the great majority of investors settled upon was EBITDA.

Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant.  

Even non-leveraged firms came to be analysed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate.  

Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.





How should cash flow be measured?

Before the junk-bond era investors looked at two components: 

• after tax earnings, (that is the profit of a business); plus 
• depreciation and amortization minus capital expenditures (that is, the net investment or disinvestment in the fixed assets of a business.)

The availability of large amounts of non-recourse financing changed things.  

Since interest expense is tax deductible, pretax, not after-tax, earnings are available to pay interest on debt; money that would have gone to pay taxes goes instead to lenders. 

A highly leveraged company thus has more available cash flow than the same business utilizing less leverage.


Notwithstanding, EBIT is not necessarily all freely available cash.

• If interest expense consumes all of EBIT, no income taxes are owed.
• If interest expense is low, however, taxes consume an appreciable portion of EBIT.

At the height of the junk-bond boom, companies could borrow an amount so great that all of EBIT (or more than all of EBIT) was frequently required for paying interest.  

In a less frothy lending environment companies cannot become so highly leveraged at will. 

• EBIT is therefore not a reasonable approximation of cash flow for them.  
• After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream.

Depreciation

Cash flow, also results from the excess of depreciation and amortization expenses over capital expenditures.  It is important to understand why this is so. 

• When a company buys a machine, it is required under GAAP to expense that machine over its useful life, a procedure known in accounting as depreciation.  
• Depreciation is a noncash expense that reduces net reported profits but not cash.  
• Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment.  
• Capital expenditures are thus a direct offset to depreciation allowances; the former is as certain a use of cash as the latter is a source.  

The timing may differ: a company may invest heavily in plant and equipment at one point and afterward generate depreciation allowances well in excess of current capital spending. 

• Whenever the plant and equipment need to be replaced, however cash must be available.  
• If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

Amortization

Amortization of goodwill is also a noncash charge but,conversely, is more of an accounting fiction than a real business expense. 

When a company is purchased for more than its tangible book value, accounting rules require the buyer to create an intangible balance-sheet asset known as goodwill to make up for the difference, and then to amortize that goodwill over forty years. 

• Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely need not be spent in the future to preserve the business. 
• Charges for goodwill amortization usually do represent free cash flow.

Why was EBITDA used?

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. 

• EBIT did not accurately measure the cash flow from a company's ongoing income stream.  
• Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.  

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.  

• In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipate sharp reductions in capital expenditures.  
• Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

What is the required level of capital expenditure for a given business?

It is not easy to determine the required level of capital expenditures for a given business.  Businesses invest in physical plant and equipment for many reasons: 

• to remain in business, 
• to compete, 
• to grow and 
• to diversify.  

Expenditures to stay in business and to compete are absolutely necessary. 

Capital expenditures required for growth are important but not usually essential.

Capital expenditures made for diversification are often not necessary at all.  

Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders.  

Since detailed capital-spending information are not readily available to investors, perhaps they simply chose to disregard it.

EBITDA by ignoring capital expenditures is flawed

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because ALL the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). 

• One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment int he business.  

This view was flawed, of course. 

• Leasehold improvements and parts of a machine are not typically financeable for any company.  
• Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.   
• An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

EBITDA:  a clear case of circular reasoning to justify high takeover prices

EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. 

This would be a clear case of circular reasoning. 

• Without high-priced takeovers there we no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.  
• This would not be the first time on Wall Street that the means we adapted to justify an end.  
• If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.

Enterprise Value Multiples

Enterprise value (EV) is calculated as the market value of the company's common stock plus the market value of outstanding preferred stock if any, plus the market value of debt, less cash and short term investment (cash equivalent).

EV
= market value of company's common stock
+ market value of outstanding preferred stock
+ market value of debt
- cash and short term investment (cash equivalent)

It can be thought of as the cost of taking over a company.



EV/EBITDA multiple

The most widely used EV multiple is the EV/EBITDA multiple.

EBITDA measures a company's income before payments to any providers of capital are made.

The EV/EBITDA multiple is often used when comparing two companies with different capital structures.


Loss-making companies usually have a positive EBITDA

Loss-making companies usually have a positive EBITDA, which allow analysts to use the EV/EBITDA multiple to value them.  

The P/E ratio is meaningless (negative) for a loss making company as its earnings are negative.

Enterprise Multiple = EV / EBITDA

What It Is:

Enterprise multiple is a financial indicator used to determine the value of a company. It is equal to a company’s enterprise value divided by its EBITDA (Earnings Before Interest, Taxes, Depreciation andAmortization).

How It Works/Example:

The enterprise multiple has many uses. In addition to helping investors determine if a company is over- or undervalued, it is also used by analysts to examine companies during the due diligence process that precedes a potential acquisition.

To determine the enterprise multiple, you much first find the company's enterprise value (market capitalization + value of debt, minority interest, and preferred shares - value of cash and cash equivalents). Once you know the company's EV, simply divide by the company's EBITDA.

Enterprise Multiple = EV/EBITDA

A company with a low enterprise multiple is considered to be an attractive takeover candidate (and investment), because it reflects a low price for the value of the company (more company for your dollar).  Enterprise multiples are compared to other companies within the same industry and not across industries in order to obtain an insightful assessment.

Why It Matters:

The enterprise multiple ratio is considered a more accurate barometer of the firm's value than the price-to-earnings (P/E) ratio since it discounts various countries taxing policies and takes into account debt and cash on hand. The enterprise multiple provides a more accurate insight into the company as it provides the acquirer with better information about the company's prospects and will prevent the acquirer from overpaying as well as avoid a potentially inferior acquisition.

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/enterprise-multiple-625

EBITDA

What is EBITDA?

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Although it sounds intimidating upon first glance, it is nowhere near as complicated as it looks. Essentially, it is a good indicator of a company's financial performance.

How do you calculate EBITDA?

EBITDA is calculated as shown by the formula below:

EBITDA = Revenues - Expenses

The expenses obviously do not include interest, taxes, depreciation, and amortization.

What is the significance of EBITDA?

EBITDA is used to analyze and compare profitability between industries and companies. One of its most important traits is that it eliminates the effects of accounting and financing decisions, which can greatly skew a company's earnings from quarter to quarter. However, this does allow the company more leeway in choosing the data to use in this calculation.

Watch out for...

EBITDA is commonly quoted by many companies, especially in the tech sector, to hide something in their finances. The companies have discretion as to what goes in EBITDA, so make sure to look at other metrics to make sure that the company you are researching really is a solid buy.

What is EV / EBITDA?

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based:  The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based.  The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money.  The DCF method has many advantages, the most important being its future-looking orientation.  This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.

Finance for Managers - Earnings-Based Valuation - EBIT Multiple

The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate.  In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's.  Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders.  How is this possible?  The answer is twofold:  the manner in which they are financed, and taxes.  If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line.  Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities.  And taxes reduce bottom-line earnings.

Consider the hypothetical scenario in table 10-a.  Notice that the two companies produce the same earnings before interest and taxes (EBIT).  But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000).  This dramatically reduces its earnings before income taxes relative to Amalgamated.  Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company.  The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process.  Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization.   Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms.  By using EBITDA in the valuation equation, this potential distortion is avoided.

Table 10-a

Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation

                                                         Amalgamated     Acme
Earnings before Interest and Taxes      $757,500        $757,500
Less:  Interest Expenses                      $110,000        $350,000
  Earnings before Income Tax              $647,500        $407,500
Less:  Income Tax                               $300,000       $187,000
  Net Income                                       $347,500       $220,500

Basic financial statements (Profit and Loss Account)

The particulars of a regular company's Profit & Loss Account would look as follows:

Revenue - Sales value generated
Cost of Goods Sold - All costs related to the sale of the goods
Gross Profit - The excess of revenue over cost of goods sold (or likewise Gross Loss if otherwise)
Operating Expenses - All remaining expenses of the operations
EBITDA - Earnings before interest, taxes, depreciation & Amortisation
Depreciation - The decrease in the value of capital assets which are expensed off
EBIT - Earnings before interest and taxes
Interest - Interest cost of borrowings
Taxes - Taxes imposed on income
Net Profit - The final bottom line



Saturday December 11, 2010

Basic financial statements interpreted

By RAYMOND ROY TIRUCHELVAM


FOR a non-finance person, evaluating a company's financial can be daunting, let alone understanding it to form an opinion. The most basic form of financial statements comprises the Profit & Loss Account or sometimes referred to as Income Statement and the Balance Sheet.

Another two statements that make a complete financial information for reporting purposes comprise the Statement of Retained Earnings and Statement of Cash Flow.

The objective of a financial statement is to provide information about the financial position, performance and changes in the position of an enterprise.

The Balance Sheet represents the financial position or net worth of a business entity on a specified date. The presentation is based on a fundamental accounting equation of Assets = Liabilities + Shareholders Fund. The main categories of assets are usually listed first, usually in order of liquidity. Next follows liabilities, short and long term, which represent payables and borrowings held by the entity.

The difference between the assets and liabilities (Assets Liabilities = Shareholders Funds), is known as Shareholders Funds, or sometimes referred to as owner's equity, that entails the company's capital plus retained earnings. Borrowings (liability) or owner's money (owner's equity) are the two means used for financing an asset.

Mathematically, over a period of time, if the assets grow bigger than the liabilities, it would mean that the entity has made a profit (which represents the essence of the Profit & Loss Account); this is reflected via an increased asset base (taking shape in many forms from cash, inventories, accounts receivable, fixed assets or investments).

Reverting to the Balance Sheet equation, the Shareholders Fund will reflect the increment. Since the entity's capital remains constant (unless the new assets are caused by new share issues), the increment is credited to a special account called Retained Earnings, as the name denotes.

Next, the Profit & Loss Account represents summarised transactions of an entity's performance over a given period, showing its profitability (or losses). Acting as the management's scorecard, it identifies the revenues and expenses undertaken which results in either a profit or a loss, based on the fundamental accounting concept of: Revenue Expenses = Profit (or Loss if expenses exceed revenue).

This in return will drive the direction of the Shareholders Fund (in particular Retained Earnings sub-category), for good (profit) or for worse (loss).

The particulars of a regular company's Profit & Loss Account would look as in Table 1.

There is also a category of item to be on the lookout called Unusual Item, which represents non-recurring non-revenue based transaction undertaken by the entity that results in a profit or loss. Examples of MAS selling aircraft, discontinuing a business line, incurring losses from natural disaster, writing down of investment value, are a few, which should be evaluated separately from the results from operations.

Due to its importance, EPS or Earnings Per Share is also required to be disclosed at the end of the Profit & Loss account. It presents the earnings divided by the total ordinary shares outstanding.

This single measure differentiates the efficiency in the earnings between companies, and represents the most important criteria in determining the price of the entity's shares and is used as a component to derive the all important PE or Price to Earnings ratio.

A large Retained Earnings balance as compared to the total Shareholders Fund, will denote a profitable company (accumulation of profits over the years), and a negative Retained Earnings (or Retained Loss) reflects the opposite. In extreme cases, the Retained Loss (debit balance) can overtake the Share Capital (credit balance), thus resulting in a negative Shareholders Fund. One surely would not want to invest in such a company.

Some listed companies, when the Retained Earnings gets so large (coupled with other factors such as inability to pay out dividend), reward the shareholders via Bonus Issue exercise, whereby part of the retained earnings are converted into new shares, accruing to existing shareholders.

This not only represents a short cut of the dividend payout, but also a tax free option via capital returns.

Raymond Roy Tiruchelvam, who has problems reconciling his gross habits with his net income is a financial planner with SABIC Group of Companies.

http://biz.thestar.com.my/news/story.asp?file=/2010/12/11/business/7567075&sec=business

What is EBITDA?

Earnings before interest, taxes, depreciation and amortization or, to give it its acronym, EBITDA, is a measure of a company's cash flow before certain deductions. It allows investors to see how much money a company is making before taxes, depreciation and amortization have been deducted. Basically, when investors place money in a company, they will want to know how much money the company has been making since their money was invested. EBITDA gives the investor an idea of how much money the company has made before its deductions. It is especially useful for a new company who has just started business and has not yet been hit with taxes, payments to creditors, and so on.

If the EBITDA figure seems to have a good growth rate, then some investors may use this figure instead of the overall net figure. It can show them that the company has a future for potential growth and that they will get a return on their investment. Investors call this looking at the EBITDA margin rather than the net margin.

There are potential problems in using the EDITDA figure. The EBITDA leaves out of lot of expenses in the final figure, so it may not be a realistic view of a company’s profitability. It also does not measure the actual cash that is flowing into the company because of the figures that it leaves out.

There are a few factors that the EBITDA neglects. These include the money required for working capital, fixed expenses and other debt payments and capital expenditures. In every business, capital expenditures are a crucial, ongoing expense. However, this is not factored into the EBITDA figure, so investors need to be wary when using the EBITDA figure as a basis for a profit margin.

There are more reliable ways for investors to calculate a company's cash income. They can use the Free Cash Flow (FCF) system. The FCF is calculated by simply deducting capital expenditures from the business cash flow figure. This takes into account at least three of the factors that the EBITDA leaves out: inventory, receivables and capital expenditures such as property and equipment.

http://www.wisegeek.com/what-is-ebitda.htm

How to Calculate EBITDA

By an eHow Contributor 

 

I want to do this! What's This?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is a measure to gauge the profitability of a corporation or business. A person need not have an MBA to understand financial calculations. EBITDA is not as complicated to calculate as the lengthy acronym would suggest.

Instructions

1. Calculate net income. To calculate net income obtain total income and subtract total expenses. Total income is defined as the amount of money obtained for services, labor or the sale of goods. Total expenses is defined as when a corporation uses up an asset or incurs a liability.
   
2. Determine income taxes. Income taxes are the total amount of taxes paid to federal, state and local governments.
   
3. Compute interest charges. Interest is the fee paid to companies or individuals that reimburses the individual or companies for the use of credit or currency.
   
4. Establish the cost of depreciation. Depreciation is the term used to define a cash (machines or property) or non-cash asset (a copyright, a trademark or brand name recognition) that loses value over time whether through aging, wear and tear or the assets becoming obsolete. There are two methods of depreciation: straight line and accelerated.
   
5. Ascertain the cost of amortization. Amortization is a method of decreasing the amounts of financial instruments over time including interest other finance charges.
   
6. Add all previously defined components. EBITDA (earnings before interest, taxes, depreciation and amortization) equals amortization plus depreciation plus interest plus net income plus income taxes. The resulting figure is then subtracted from total expense. This final figure is then subtracted from total revenue to arrive at EBITDA.
   

Read more: How to Calculate EBITDA | eHow.com http://www.ehow.com/how_2060379_calculate-ebitda.html#ixzz0yEIhiJ2i

Tips & Warnings

• EBITDA is a financial calculation that is NOT regulated by GAAP (Generally Accepted Accounting Principles) and therefore can be manipulated to a company's own ends.

EBITDA: Challenging The Calculation

by Lisa Smith (Contact Author | Biography) 

EBITDA has a bad rap in the financial world, but does this financial measure really deserve the investor distaste? EBITDA, an acronym for "earnings before interest, taxes, depreciation and amortization," is an often-used measure of the value of a business. But critics of this value often point out that it is a dangerous and misleading number, due to the fact that it is often confused with cash flow. In this article we'll show you how this number can actually help investors create an apples-to-apples comparison, without leaving a bitter aftertaste.

The Calculation

EBITDA is calculated by taking operating income and adding depreciation and amortization expenses back to it. EBITDA is used to analyze a company's operating profitability before non-operating expenses (such as interest and "other" non-core expenses) and non-cash charges (depreciation and amortization). So, why is this simple figure continually reviled in the financial industry?
The Critics

Factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy. A look back at the dotcoms provides countless examples of firms that had no hope, no future and certainly no earnings, but became the darlings of the investment world. The use of EBITDA as measure of financial health made these firms look attractive.
Likewise, EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues and interest, taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble.
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 and includes the changes in working capital that also use or provide cash (such as changes in receivables, payables and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a company is losing money because it isn't making any sales. (To learn more about cash flow, see The Essentials Of Cash Flow and Analyze Cash Flow The Easy Way.)

---

The Cheerleaders

Despite the critics, there are many who favor this handy equation. Several facts are lost in all the complaining about EBITDA, but they are open promoted by the value's cheerleaders.

1. The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow available to pay debt on long-term assets, such as equipment and other items with a lifespan measured in decades rather than years. Dividing EBITDA by the amount of required debt payments yields a debt coverage ratio. Factoring out the "ITDA" of EBITDA was designed to account for the cost of the long-term assets and provide a look at the profits that would be left after the cost of these tools was taken into consideration. This is the pre-1980s use of EBIDTA, and is a perfectly legitimate calculation.
   
2. Another factor that is often overlooked is that for an EBITDA estimate to be reasonably accurate, the company under evaluation must have legitimate profitability. Using EBITDA to evaluate old-line industrial firms is likely to produce useful results. This idea was lost during the 1980s, when leveraged buyouts were fashionable, and EBITDA began to be used as a proxy for cash flow. This evolved into the more recent practice of using EBITDA to evaluate unprofitable dotcoms as well as firms such as telecoms, where technology upgrades are a constant expense.
   
3. EBITDA can also be used to compare companies against each other and against industry averages.
   
4. In addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous factors and allows a more "apples-to-apples" comparison.

Ultimately, EBITDA should not replace the measure of cash flow, which includes the significant factor of changes in working capital. Remember "cash is king" because it shows "true" profitability and a company's ability to continue operations.

Example - EBITDA Analysis The experience of the W.T. Grant Company provides a good illustration of the importance of cash generation over EBITDA. Grant was a general retailer in the time before commercial malls and was a blue chip stock of its day. Unfortunately, management made several mistakes. Inventory levels increased, and the company needed to borrow heavily to keep its doors open. Because of the heavy debt load, Grant eventually went out of business, and the top analysts of the day that focused only on EBITDA missed the negative cash flows. Many of the missed calls of the end of the dotcom era mirror the recommendations Wall Street once made for Grant. In this case, the old cliché is right: history does tend repeat itself. Investors should heed this warning.

The Caution

In both cases No.1 and No.2 listed above, EBITDA is likely to produce misleading results. Debt on long-term assets is easy to predict and plan for, while short-term debt is not. Lack of profitability isn't a good sign of business health regardless of EBITDA. In these cases, rather than using EBITDA to determine a company's health and put a valuation on the firm, it should be used to determine how long the firm can continue to service its debt without additional financing.
A good analyst understands these facts and uses the calculations accordingly in addition to his or her other proprietary and individual estimates.

The Conclusion

EBITDA doesn't exist in a vacuum. The measure's bad reputation is more a result of overexposure and improper use than anything else. Just as a shovel is effective for digging holes, but wouldn't be the best tool for tightening screws or inflating tires, so EBITDA shouldn't be used as a one-size-fits-all, stand-alone tool for evaluating corporate profitability. This is a particularly valid point when one considers that EBITDA calculations do not conform to generally accepted accounting principles (GAAPs).
Like any other measure, EBITDA is only a single indicator. To develop a full picture of the health of any given firm, a multitude of measures must be taken into consideration. If identifying great companies was as simple a checking a single number, everybody would be checking that number and professional analysts would cease to exist. (For more insight on EBITDA, read A Clear Look At EBITDA.)


by Lisa Smith (Contact Author | Biography)

Filed Under: Bonds, Fundamental Analysis, Options

 

 http://www.investopedia.com/articles/analyst/020602.asp

Earnings before interest, taxes, depreciation and amortization (EBITDA)

EBITDA «ee-bit-dah» is the initialism for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the income statement are reversed out from the bottom-line net income. It purports to measure cash earnings without accrual accounting, canceling tax-jurisdiction effects, and canceling the effects of different capital structures.

EBITDA differs from the operating cash flow in a cash flow statement primarily by excluding payments for taxes or interest as well as changes in working capital. EBITDA also differs from free cash flow because it excludes cash requirements for replacing capital assets (capex).

EBITDA Margin refers to EBITDA divided by total revenue. EBITDA margin measures the extent to which cash operating expenses use up revenue.

Contents
* 1 Use by private equity investors
* 2 Use by debtholders
* 3 Use by shareholders
* 4 Unprofitable businesses

Use by private equity investors

In the process of purchase, long-life assets will be revalued to market values. Their depreciation and amortization will necessarily be changed. Control of the business allows the purchaser to move it to a new tax jurisdiction and to refinance its debt.

Use by debtholders

EBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be used to pay interest and repay the principal. Since interest is paid before income tax is calculated, the debtholder can ignore taxes. They are not interested in whether the business can replace its assets when they wear out,therefore can ignore capital amortization and depreciation.

There are two EBITDA metrics used.

1. The measure of a debt's pay-back period is Debt/EBITDA. The longer the payback period, the greater the risk. The metric presumes that the business has stopped making interest payments (because interest is added back). But it is argued that once that happens the debtholder is unlikely to wait around (say) three years to recover their principal while the business continues to operate in default. So does the metric measure anything? There is also the problem of adding back taxes. This metric ignores all tax expenses even though a good portion are cash payments, and the government gets paid first. Principal repayments are not tax-deductible.

2. One interest coverage ratio (EBITDA /Interest Expense) is used to determine a firm's ability to pay interest on outstanding debt. The greater the multiple of cash available for interest payments, the less risk to the lender. The greater the year-to-year variance in EBITDA, the greater the risk. Because interest is tax-deductible it is appropriate to back out the tax effects of the interest, but this metric ignores all taxes.

The ratios can be customized by reducing Debt by any cash on the balance sheet or by deducting maintenance CapEx from EBITDA to form a measure closer to free cash flow.

Use by shareholders

Public investors' use of EBITDA arose from their perception that accountants' measure of profits, using accrual accounting was manipulated, that a measure of cash earnings would be more reliable.

It is true that PE can use this metric. And it is true the professional analysts using detailed discounted cash flow models should replace non-cash expenses with projected time-weighted payments. But none of that applies to retail investors' reality.

EBITDA does NOT measure cash earnings because it omits all the tax expenses even though a good portion are cash payments. It also fails to correct for other non-cash expenses, e.g. warranty expense, bad debt allowance, inventory write-down, stock options granted.

It does not include the cash flows from changes in working capital. Suppose a business sells all its opening inventory in a year and replaces the same number of units but at a higher price because of inflation. The profits of a company using FIFO inventory valuation will not include that extra cash cost. Suppose the business is expanding and need to stock a larger number of units. That additional cash cost is not in anyone's EBITDA measure.

When using this metric to replace accountant's earnings it presumes to measure an economic profit. But any economic profit must include the cost of capital and the degradation of long-life assets. This metric simply ignores both. Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?" Depreciation may not be exact but it is the most practical method available. It succeeds in equating the positions of companies using three different ways to finance long-life assets. It can be interpreted as:

1. the allocation of the original cost, at a later date, when the asset was used to generate revenue. The time-value-of-money (same argument used above) means that depreciation may understate the cost.
2. the amount of cash required to be retained in order to finance the eventual replacement asset. Since inflation is the basis for time-value-of-money, the amounts set aside today must be invested and grow in value in order to pay the inflated price in the future.
3. the decrease in value of the balance sheet asset since the last reporting period. Assets wear out with use, and will eventually have to be replaced.

Unprofitable businesses

When comparing businesses with non profits, their potential to make profit is more important than their Net Loss. Since taxes on losses will be misleading in this context, taxes can be ignored. Capital expenditures and their related debt result in fixed costs. These are of less importance than the variable costs that can be expected to grow with increasing sales volume, in order to cover the fixed costs. So depreciation and interest costs are of less importance. It is likely that an unprofitable business is burning cash (has a negative cash flow), so investors are most concerned with "how long the cash will last before the business must get more financing" (resulting in debt or equity dilution).

EBITDA is not used as a valuation metric in these circumstances. It is a starting point on which future growth is applied and future profitability discounted back to the present. Equity owners only benefit from net profits, after all the expenses are paid.

During the dot com bubble companies promoted their stock by emphasising either EBITDA or pro forma earnings in their financial reports, and explaining away the (often poor) "income" number. This would involve ignoring one-time write-offs, asset impairments and other costs deemed to be non-recurring. Because EBITDA (and its variations) are not measures generally accepted under U.S. GAAP, the U.S. Securities and Exchange Commission requires that companies registering securities with it (and when filing its periodic reports) reconcile EBITDA to net income in order to avoid misleading investors.

http://en.wikipedia.org/wiki/Earnings_before_interest,_taxes,_depreciation_and_amortization


EV/EBITDA
From Wikipedia, the free encyclopedia

EV/EBITDA is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio.

An advantage of this multiple is that it is capital structure-neutral. Therefore, this multiple can be used for direct cross-companies application.

Often, an industry average EV/EBITDA multiple is calculated on a sample of listed companies to benchmark against. An index now exists providing an average EV/EBITDA multiple on a wide sample of transactions on private companies in the Eurozone (Argos Soditic index).

The reciprocate multiple EBITDA/EV is used as a cash return on investment.

http://en.wikipedia.org/wiki/EV/EBITDA

EV to EBITDA

http://pennysleuth.com/investing-in-the-railroad-industry/

Income Statement Format with EBIT and EBITDA

Shareholder value and Economic Profit

Shareholders invest in a company to make a profit.  This can come from an increase in the share price and/or the dividends the company pays.

The challenge is to find a measure of business performance that correlates with share price movements.  Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.



EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA)

Profit is not a good measure of the value a business is generating for its shareholders.  Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends.  And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.

In calculating profit, depreciation is included as a cost.

Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time.  We can measure earnings before interest, tax, depreciation and amortisation - EBITDA!  This is the amount of operating profit that will eventually be turned into cash.  But EBITDA alone doesn't tell us if we are creating value.


Economic profit or Economic Value Added (EVA)

Economic profit (EP) takes account of the fact that investors have choices.  They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank.  Every investment has a certain amount of risk, and a level of reward.

If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.  

• Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.  
• A fall in EP goes with a reduction in share price, and destruction of shareholder value.

Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'.  The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.

If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry.  This is the 'cost of equity'.

Most companies are financed partly by shareholders' funds, and partly by bank loans.  So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well.  This is known as the 'weighted average cost of capital', or the WACC rate.

Economic profit is calculated by

• subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.  
• Tax is also deducted because this is paid out of cash flow.  
• Interest is not deducted, as the capital charge has already taken this into account.

Economic profit = Profit (Earnings) - Tax - Capital charge

Capital charge = Net Asset Value of a business X WACC rate


Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html

Buffett (1989): His view on high growth rates, EBITDA and zero coupon bonds

We saw Warren Buffett make some significant dents in the efficient market theory and also got to know his take on arbitrage. Let us see what the master has to say in his 1989 letter to shareholders.

Have you ever wondered why despite such enormous wealth and infrastructure, the US economy canters at a mere 3%-4% growth rate per annum and why a country like India, which has very little infrastructure in comparison to the US, is galloping at 7%-8% rate. Or better still, what happened to the 40%-50% growth rates that the Indian IT companies notched up so successfully in the not so recent past? The master has the following explanation to these phenomena:

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."

Indeed, in a world where resources are limited, consistently high growth rates would create pressure on those resources, thus resulting into either exhaustion of the resources or slowing down of growth. To better illustrate this point, let us return to the Indian IT industry. The demand for qualified IT professionals (a limited resource as we can produce only so much per year) has been so high in recent times that this has resulted in a disproportionate rise in salaries and attrition levels, thus impeding profit growth. Further, it is much easy to double revenues on a base of Rs 500 - Rs 600 m than on a base of Rs 50,000 m - Rs 60,000 m. Hence, those who are expecting these companies to grow at the same rate as in the past, might be in for some real surprise.

Another important topic that the master has touched upon in his 1989 letter is the gradual deterioration in the quality of representation of a company's true cash flow by certain promoters and their advisors in order to justify a shaky deal. While earlier, a company's cash flow, to justify its debt carrying capacity took into account its normal capex needs and modest reduction in debt per year, things had come to such a pass that EBITDA emerged as a substitute for a company's cash flow. Important to note that EBITDA not only excludes the normal capex needs of the company, but it was deemed enough to cover just the interest expense on debt and not the repayment of debt. This is what the master had to say on such practices:

"To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures."

Thus, since EBITDA does not even cover the normal capex needs of the company, the master advises investors to be wary of companies and investment bankers who rely on these yardsticks to justify a leveraged deal. The master also touches upon a special type of bond known as the zero coupon bonds and goes on to add that whenever the inherent advantage that these bonds offer (deferring interest payment and not recording them till the maturity of bonds) combine with lax standards for cash flow estimation like the EBITDA, it sure is a recipe for disaster. This is what he has to say on the combination of both:

"Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures."

http://www.equitymaster.com/detail.asp?date=9/20/2007&story=3

A bit of EBITDA

EBITDA measures operating cash generated before:

• non-operating interest,
• taxes, and,
• noncash depreciation & amortization.

In a sense, EBITDA is operating income before:

• bankers (non-operating interest), and
• government (taxes), and
• accountants (noncash depreciation & amortization).

EBITDA is also sometimes looked at as a liquidity measure:

• Positive-EBITDA companies can service their debt, while
• Negative-EBITDA companies must borrow more.

Beware of glowing announcements of positive EBITDA, especially when accompanied by losses on the earnings statement.