Why EBITDA Matters to Investors

It's understandable why you'd want to focus on the bottom line. But there's genuine utility in knowing what to factor out of it.

Motley Fool Staff
Motley Fool Staff
Jul 2, 2019 at 9:22AM
Other

It would be hard to find a podcast-hosting duo more fully invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they even put "Answers" in their show's name! This week, they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they have recruited senior analyst Ron Gross to help out.

In this segment, they are presented with a simple question: "Why do we care about EBITDA?" Well, that acronym stands for "earnings before interest, taxes, depreciation, and amortization," and it's a shorthand tool for estimating operating cash flow. And there are plenty of reasons investors will want to know that.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on June 25, 2019.

Alison Southwick: The next question comes from P.T. in Utah. "Why do we care about EBITDA?"

Robert Gross: Good question!

Southwick: "I know what it stands for, I know what it means, but I must not know what it means because I always think, 'Why not tell me E-A-B-I-T-D-A? Earnings after...'" Oh, my goodness! Now we've got a lot.

Ron Gross: We'll get into it.

Southwick: "EBITDA is like G-B-P-B-P-C-I-S [grades before parties, beer parties, and calling in sick.]" Oh, so funny!

Gross: Oh, boy! For the rest of the audience, let's define EBITDA: earnings before interest, taxes, depreciation, and amortization. It's a quick-and-dirty method of estimating operating cash flow. All over Wall Street investment bankers -- all over the world right now -- are talking about EBITDA because it's just a really quick way to think about cash flow.

Now I say operating cash flow rather than total cash flow or free cash flow because this just focuses on the operating business. It removes interest because it's before interest. Interest is not an operating decision of management -- it's a financing capital decision of management. It's different than do you make a good product and do you sell it for a fair price and make a profit? So if you want to just look at the operating business, let's remove the effect of interest.

We also take out taxes because there's a lot of decisions that affect taxes. Everybody has to pay them by law but if we really just want to focus on do you sell your product and do you make a profit, let's just remove taxes for analysis purposes.

And finally the bigger deal, here, is we want to remove the impact of depreciation and amortization, which are non-cash expenses. When you buy a big manufacturing facility for $500 million, GAAP accounting lets you divide that amount by 15 or 20 years and deduct from your income that 1/15th as an expense, which lowers your profits, which lowers the taxes you have to pay. So it's a tax benefit. But it's non-cash. You didn't really have that expense.

So we adjust for it to get an idea of the actual cash flow a company has. If you owned 100% of that company yourself, how much actual cash could you put in your pocket at the end of each year? That's different than GAAP net income. It's not the same thing. So we make adjustments, here, to look at operating cash flow to get a better understanding of how this business is performing and how much cash they're actually producing.

Southwick: And you're fine with EBITDA?

Gross: I'm a big fan!

Brokamp: A big fan!