I wish I knew what Ebitda was, but I’m too embarrassed to ask

Earnings before interest, tax, depreciation and amortisation (Ebitda) is a measure of profit that can make it easier to compare the valuation of two companies, or to give a clearer view of a firm’s underlying profitability. It looks at earnings before the effects of capital structure (how the company is funded), taxes and accounting conventions (depreciation and amortisation are charged to earnings, but how companies choose to write down the value of tangible and intangible assets can be very different).

So, for example, Ebitda enables investors to compare two businesses on a like-for-like basis by taking their enterprise values (EV), the market value of all their shares in issue, plus net borrowing or excluding net cash, and comparing this with Ebitda. The lower the EV/Ebitda ratio, the cheaper the stock – it’s like a price/earnings ratio that uses a more easily comparable measure of earnings and also takes debt into account.

Ebitda came into common use in the US in the 1980s, during the boom in leveraged buyouts (LBOs). It was useful as a measure of the ability of a company to service a higher level of debt, which in turn had a big impact on what a prospective buyer would be willing to pay (because as with using a mortgage to buy a

property, if you can use more debt to buy a company, the potential return on the capital you’ve invested goes up). It also became popular in industries with costly assets that had to be written down over longer periods.

Today it is widely quoted, even where its value is debatable. It’s important to remember that Ebitda’s strength – that it represents profit before certain costs – is also its weakness, because it doesn’t represent profits that can be paid to investors (as opposed to helping privateequity buyers gauge how much debt a firm could take on). After all, companies still need to replace assets, pay tax and meet interest bills on debt, all of which reduces profits for investors.