What is EBITDA?

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EBITDA is probably the most common non-GAAP metric that companies report. It is a rough guide to show how much cash a business generates.

EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.

EBITDA is a major financial indicator used to evaluate companies' profitability with different capital structures.

The cable industry pioneer John Malone developed the metric in the 1970s to sell investors on his company’s true profitability, which he believed was not accomplished by GAAP figures such as earnings per share.

How is EBITDA calculated?

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Calculating EBITDA requires information from the company's income statement and cash flow statement.

Here's one way to do it:

Net Income

+ Interest Expense (Income Statement)

+ Taxes (Income Statement)

+ Depreciation (Cash Flow Statement

+ Amortization (Cash Flow Statement)

Pros and cons of EBITDA

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Some investors love EBITDA. Others despise it.

Charlie Munger, Warren Buffett’s famed business partner, called EBITDA "bulls**t earnings" because it did not always accurately reflect a company’s earnings.

For instance, because EBITDA does not consider all business activities, it might overstate cash flow.

For instance, it backs out depreciation and amortization as expenses.

Depreciation is when a tangible asset's value is gradually reduced over time to account for wear and tear. For instance, a new piece of factory equipment is worth more than it will be after years of heavy use.  

What depreciation is for a physical asset, amortization is its counterpart for intangible assets, usually financial instruments like a loan.

Usually, when companies report non-GAAP results, they back out depreciation and amortization because no cash is leaving the company based on either of these metrics when the report is made.

However, factory equipment needs to eventually be replaced, so depreciation is a very real expense over the life of a business.

Buffett and Munger prefer to look at EBT, which stands for earnings before taxes.

This allows them to compare a business's earnings yield to a bond’s earnings yield (which is also a pre-tax number).

Key Takeaway

EBITDA is a popular non-GAAP metric that provides valuable insights into a company's cash generation and profitability, making it a key tool for investors.

However, while it offers a useful perspective, it has its limitations, particularly in its exclusion of important expenses like depreciation and amortization. Critics, including Warren Buffett and Charlie Munger, caution that relying solely on EBITDA can lead to an inflated view of a company's financial health.

Therefore, it's essential for investors to consider EBITDA alongside other financial metrics and analyses to gain a well-rounded understanding of a company's true performance and potential.