What is EBITDA?
In the realm of mergers and acquisitions, there are numerous factors that companies or firms must consider in selling or buying. While people typically tend to focus on strategy, financing and overall structure post-merger or post-acquisition, there are always tax considerations that will influence the decision to make a deal, and how to make that deal. On top of this, companies or firms must consider how assets may depreciate over time such that the value of the company (and thus its stock) changes. Yet, there is a key metric involved in big deals called EBITDA, which stands for “earnings before interest, taxes, depreciation and amortization.” EBITDA measures an entity’s net income without factoring in interest it will have to pay on financing, taxes it will have to pay, and depreciation of the value of its assets. It also ignores amortization, which has to do with the structure and schedule for paying off debt and how much of that goes toward interest and how much of it goes toward principal on the debt, or how much is spent on a certain expense over a specific amount of time such that money is allocated on an annual basis. Amortization in some circumstances can give rise to tax deductions for a company. While not a pure measure of cash flow, it is somewhat analogous because it looks at earnings before those other payments are made.
As profiled recently in the New York Times Dealbook, investors and analysts use this measurement to assess “whether a company or its stock is overvalued or undervalued.” As the article indicates, when creditors provide financing for a deal (such as in a leveraged buyout with loans or bonds, for example), they will calculated the EBITDA value of a deal, and can compare companies’ profitability. A positive EBITDA can indicate good profitability, while a low or negative EBITDA calculation means there may not be enough cash flow for the company. EBITDA may be particularly advantageous to compare companies irrespective of where they are registered and do business, since different jurisdictions have different tax laws. Critics, though, see EBITDA as a “gimmick” by accountants, and it is not necessarily considered a general accounting practice, though it has become increasingly popular in recent decades, particularly for mergers and acquisitions.
One wrinkle with EBITDA, however, is that it can often be calculated and manipulated in different ways. As the Dealbook article discusses, in citing a report from Moody’s Investors Service, debt issuers are tailoring EBITDA to make issuing that debt more palatable. For example, by adding “projected savings” to the pot, even though it is difficult to sure whether there will be savings or just how much the savings will actually be. The investors/creditors that rely on the EBITDA calculation in deciding whether or not to invest in a company that will earn high profit have reportedly not shown much skepticism in how EBITDA is being calculated. Thus, this can lead to overstated profitability for a company, and investors willing to jump on board where there is not nearly the prospect of profit that they think, or may simply be willing to look past those weaknesses in the calculation because of an urgency to get deals done in an economy and market that is rebounding and even heating up in some ways.