Define
Earnings Before Interest, Taxes, Depreciation, and Amortization or EBITDA is a financial metric commonly used to evaluate a company's profitability before accounting for non-operating expenses and non-cash items such as interest, taxes, depreciation, and amortization.
EBITDA is calculated by taking a company's Revenue and adding back depreciation and amortization expenses, as well as any interest and taxes that were deducted from the operating income. This gives investors and analysts a better idea of the company's actual cash flow and operational efficiency, as it excludes items that can be affected by accounting decisions or one-time events.
EBITDA is often used as a valuation metric, particularly for companies with a lot of debt or significant capital expenditures, as it provides a clearer picture of a company's underlying financial performance. However, it's important to note that EBITDA does not get impacted by capital structure, which can have a significant impact on a company's financial health.
What Formula?
EBITDA = EBITDA / Net Revenue x 100%
Adjusted EBITDA = Adjusted EBITDA / Net Revenue X 100%
What Components?
A. EBITDA and Adjusted EBITDA
EBITDA = EBIT + Depreciation and Amortization
EBITDA can be calculated using both Top-down approach and Bottom-up approach
1. Top-Down Approach
EBITDA = Revenue Less: Cost of Goods Sold Less: Operating Expenses
Special attention should be given to Depreciation, Amortization expenses and non-operating incomes and expenses, as companies hide these under Cost of Goods Sold and Operating expenses. Further, revenues should only income operating income.
Though it is difficult to distinguish between operating and non-operating incomes and expenses, but care should be taken that these are not included in the calculation of EBITDA. To see what is operating and what is not operating, an analyst should refer to:
a. Notes to Accounts
b. Analysis provided in Management Discussion and Analysis section of annual reports
c. Business Units and products and services provided by the firm in question
Operating expenses
Operating expenses depend on the nature of business the firm in question is providing. An illustrative list is provided here for reference.
Or
Adjusted EBITDA under Top-down approach
2. Bottom-up Approach – EBITDA
To estimate EBITDA using the bottom-up approach, add all items that are subtracted to calculate operating income from Income (Loss) Before Tax and subtract all items that are added to calculate EBITDA from Income (Loss) Before Tax. After that, add depreciation & amortization.
Intel
Bottom-up Approach – Adjusted EBITDA
Where can I find them - Financial Statement Linkages?
Real Company Analysis - ConocoPhillips
Let’s take the example of ConocoPhillips, a US Oil and Gas company engaged in Exploration & Production of Oil and Gas. The annual reports can be found at https://www.conocophillips.com/investor-relations/. In 2012 ConocoPhillips Spins Off its refining pipelines and chemicals division into a new company, Phillips66.
As can be observed, ConocoPhillips does not report Operating Income or EBIT or EBITDA but Income (loss) Before Income Taxes. It can be calculated using a Top-down formula. EBITDA = Revenue – Cost of Goods sold - Operating costs.
Further, the annual reports do not explicitly have Cost of Goods Sold (COGS) line item. Therefore, either we separately calculate COGS or include all costs under operating costs. To estimate COGS, we need to understand the core operations of the firm in question. However, the difficulty in doing that is some firms do not provide details of the costs of operations and mix them up with operating costs.
Top-down Approach
1. Taxes other than income taxes
2. Accretion on discounted liabilities
3. Interest and debt expense
4. Other expenses
5. Foreign currency transactions gains (losses)
Adjustment to revenue section
If we see the revenue section of the annual report it includes equity in earnings of affiliates, gain on dispositions and other income (Loss). These must be removed from revenue calculation as they are not core operation incomes and gains. A brief description of these items is as below:
a. Earnings of affiliates
Companies have influential, but not a controlling equity interest in other firms (defined as ownership of 20% to 50%). They will account for income from their equity ownership as a proportional share of the investee’s earnings as “Equity in Affiliates” on their income statement using equity method.
b. Gain on dispositions
These are gains from disposal of oil and gas assets. The annual report for 2022 reports this as follows:
“Gain on dispositions increased $591 million in 2022, primarily due to the recognition of a gain of $534 million from our Indonesia divestiture, the absence of a $179 million loss associated with the sale of noncore assets in our Other International segment and higher contingent payments in our Canada and Lower 48 segments than in 2021. These increases were partially offset by the absence of a $200 million gain for a FID bonus associated with our Australia-West divestiture recognized in the first quarter of 2021. See Note 3.
c. Other income (Loss)
These are market-to-market gains associated with ConocoPhillips’s Cenovus Energy (CVE) common shares. Again, annual report 2022 reports this as follows:
Note 5—Investment in Cenovus Energy
At December 31, 2021, we held 91 million common shares of Cenovus Energy (CVE), which approximated 4.5 percent of the issued and outstanding common shares of CVE. Those shares were carried on our balance sheet at fair value of $1.1 billion, based on NYSE closing price of $12.28 per share on the last day of trading for the period. During the first quarter of 2022, we sold our remaining 91 million shares, recognizing proceeds of $1.4 billion.
“Other income (loss) decreased $699 million in 2022, primarily due to the absence of mark-to-market gains associated with our CVE common shares, which were fully divested in the first quarter of 2022. See Note 5. The decrease was partially offset by higher interest income earned due to rising rates and investments.”
“In 2022, we completed the monetization of our investment in CVE common shares that we began in May 2021. By the end of the first quarter of 2022, we fully divested of our investment, recognizing proceeds of $1.4 billion and directing proceeds toward our existing share repurchase program. Since inception, we generated total proceeds of $2.5 billion. See Note 5. Other proceeds from dispositions received in the current year include our divestitures in Asia Pacific and Lower 48 segments for approximately $1.5 billion after customary adjustments and $500 million in contingent payments associated with prior divestitures. See Note 3”
“Financial assets and liabilities reported at fair value on a recurring basis primarily include our investment in CVE common shares, our investments in debt securities classified as available for sale, and commodity derivatives”
The key thing to note is that these incomes or expenses are not included in EBITDA calculation as these are non-operating expenses or incomes or expenses from financial activities. The calculation of EBITDA margins for ConocoPhillips are as follows:
Bottom-up - EBITDA
Both top-down or bottom-up will result in same EBITDA margins.
How to interpret?
EBITDA and Adjusted EBITDA is the mother of all metrics used by investors for valuation of a firm as it is used as a measure of cash generation also it is used to value companies using EBITDA multiples like EV/EBITDA margins. However, that is not the case. EBITDA margins helps us understand how much money a firm makes per dollar of sales after taking care of its cost of goods sold and operating costs. Further, it tells us how much money is left, after paying operating expenses, for paying off its financial expenses.
Comparison
Comparison can be done in the following ways:
1. Temporal Comparison, i.e. time series trend analysis
2. Comparison with Industry benchmark
3. Comparison with Industry Average or close peers / competitors
Remember when we compare ratios against any average it shall be calculated with same formula otherwise it will result in erroneous comparison.
1. Trend Analysis
As can be seen from our example, ConocoPhillips EBITDA margins have been consistently rising except for 2020. The key reason behind it is drastic fall of revenues from US$32,567 Million to US$18,784 Million.
2. Comparison with Industry Average or close Peers:
But if we compare it with average (median) EBITDA Margin of close peers, we find ConocoPhillips has outperformed them by quite a margin. It is important to understand that when we compare ratio with peers/competitors, the selection of right peers/competitor is very important. Direct competitors which sell similar if not exactly same type of product or service, in terms of functionality and not form, shall only be compared.
What Strategic Implications
Firms that have EBITDA consistently above average industry or peers sustainable competitive advantage. If we take the numerator of the ROCE ratio which is EBIT and break it further, we see it dependent on Price, Volume of product sold or frequency of services rendered and cost of service. Firms that can charge premium price or have lower costs will consistently perform better in terms of ROCE compared to WACC.
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