How much is a company worth to you? As a stock market investor, that’s a question that you answer on a regular basis. Anytime you buy or sell a stock, you’re answering the value question. But how should you assess the value of a company?
Most DIY investors will consider many statistics when they make a buy or sell decision. Each investor needs to follow their own rules. However, most single stock investors will incorporate earnings rules into their company valuation. In this post, we’ll compare two of the most common earnings metrics, and we’ll explain best practices for using these metrics.
What are EBIT and EBITDA?
EBIT stands for Earnings Before Interest and Taxes. It is sometimes called operating profit. You calculate this using the following formula:
EBIT= Company Revenue – Cost of Goods Sold – General Expenses (Such as wages and benefits) – Depreciation and Amortization Expenses – Other Expenses (Travel, perks, etc.)
EBIT is an earnings figure that excludes two major expenses that every corporation faces. These expenses include income taxes and interest paid on debts. Ignoring these major expenses may seem crazy, but EBIT can be a useful metric. EBIT explains how much money a company makes without considering how they structure their debts or the company’s tax burden. It can help you determine a company’s earning potential.
Not every company reports EBIT because EBIT doesn’t line up with standard accounting procedures.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization.
EBITDA= Company Revenue – Cost of Goods Sold – General Expenses (Such as wages and benefits) – Other Expenses (Travel, perks, etc.)
Like EBIT, EBITDA excludes taxes and interest, but it also excludes depreciation and amortization expenses. Investors like to look at EBITDA because depreciation and interest tend to vary across companies based on when a company made a Capital Investment. Like EBIT, EBITDA is not an accounting metric. Therefore, not every company reports it.
Should I use EBIT or EBITDA?
Most investors build investment rules around EBITDA. They generally want to buy stocks that show a high EBITDA relative to other companies in the same sector. EBITDA gives investors the opportunity to ignore forms of financing, political jurisdictions etc. Instead, investors can focus just on the profitability. EBITDA is one of the cleanest earnings metrics for investors to use.
However, excluding depreciation and amortization can be a serious mistake. Investors need to take into account management practices. Companies really pay these expenses, and its important for investors to take these into account.
On the other hand, EBIT is much messier. Investors need to determine if capital investments have an undue influence on a low EBIT. However, EBIT takes into account capital expenditures which are necessary for ongoing operations.
At the end of the day, each investor must choose whether EBIT or EBITDA makes more sense in their analysis.
What traps should investors avoid?
As we mentioned above, EBIT and EBITDA can help you understand the potential earnings of a company, but they are far from perfect. In capital intensive industries (such as Telecomm or Utilities) its more popular to use EBITDA. This is because depreciation and amortization have a huge influence in these sectors. In tech, using EBIT tends to be a better decision.
Whenever you use EBIT or EBITDA, you should compare to companies in the same sector. Different sectors have such unique structures that it renders both factors meaningless.
Whichever route you choose to go, don’t use earnings as the only variable in your buy and sell decision. Both metrics are imperfect, and neither captures the future value of earnings. Use EBIT or EBITDA as a part of your rules, but don’t use them exclusively.