EBITDA uncovered: A useful way to compare two companies

Julie Brownlee, Fsp Invest, 29 Dec. 2014

Tags: ebidta, what is ebidta, company valuations, valuation, investing,

When it comes to comparing the performance of different companies, you can encounter problems. Different companies have different taxation systems and different accounting policies.

One way to overcome this is to use EBITDA.

So what is EBITDA? What’s the best way to use it? And are there any flaws associated with it?

Let’s take a closer look…

Why EBITDA is useful

EBITDA stands for earnings before interest, tax, depreciation and amortisation. You can use it to compare the performance of two companies.

What’s useful about using EBITDA is it overcomes the problems encountered when you compare companies using other profit measures, such as earnings per share (EPS).

There are some factors that can affect these profit measures, such as:

  • If the companies use different accounting policies on the depreciation of fixed assets;
  • If the companies have different levels of debt; and
  • If the companies have different tax rates.

What EBITDA does is look at profit levels before these factors affect profits.

How to check the valuation of a company

You can compare the valuation of different companies by taking the enterprise value (that’s the market value of all the shares in issues, plus net borrowing or less net cash) and comparing that to EBITDA (EV/EBITDA).

The lower the EV/EBITDA ratio, the cheaper the company is.

The pitfalls of using EBITDA

EBITDA can be useful, but some misuse it as a measure of value.

EPS also has its problems, but at least it comes after a charge for replacing existing assets (depreciation), interest on borrowings and tax.

To give a good measure of a company, it’s best to use a figure that’s basis is an amount that a company can pay to investors. That rules out EBITDA.

An alternative is to focus on a company’s free cash flow. You can read more about doing that here.

So there you have it. EBITDA, a useful way to compare two companies.

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