If you’re new to investing, you may have heard the term EBITDA in relation to a company’s value. If you’re not familiar with the concept, here are some basic questions, and answers, that may help you use this tool to evaluate your potential investments.
What Is EBITDA?
A key measurement of a company’s profitability is its earnings before interest, taxes, depreciation, and amortization, or its EBITDA. Rather than just looking at a balance sheet or net income report, analysts determine a business’s value by looking at its EBITDA to calculate how much the company is profiting from its endeavors. Using a figure like this, it’s easier for investors to see how one company’s overall value compares to others in its field, since greater income does not necessarily lead to increased profitability.
How Do You Calculate EBITDA?
Data found on a company’s balance sheet is used to calculate EBITDA. Although companies are not required to disclose this figure as part of their mandatory financial reporting, it’s fairly simple to get this number on your own. As the acronym implies, the standard formula for arriving at a company’s EBITDA is the adding together of net profit, interest expenses, taxes, depreciation, and amortization. Each figure must be accurate to avoid undervaluation or overvaluation of the company’s profitability. If you are evaluating a company’s worth, just review its balance sheet and use simple math to arrive at the business’s EBITDA.
How Do You Use EBITDA To Determine Value?
The EBITDA figure alone provides little insight into a company’s profitability, so one additional calculation is needed to arrive at a useful number. By dividing EBITDA by total revenue, a percentage, or margin, will be arrived at which will bring you to a benchmark by which you can judge a single company or compare it to others. Because a giant player in any given industry may rake in far more income than a smaller operation, calculating EBITDA margins is crucial when it comes to comparing the profitability of dissimilarly-sized operations.
What Is a Good EBITDA Margin?
Each industry has different benchmarks for what is considered a strong EBITDA margin. That’s why the figure is most useful when evaluating companies within the same sector; comparing the EBITDA of an oil producer to that of a clothing retailer may not provide much insight into which is the more valuable. Additionally, EBITDA can be impacted by economic factors such as market uncertainty, jobless rates, social movements, etc. In general, if you are hoping to identify companies with strong profitability, and therefore value, in which to invest, look for businesses with margins that are high relative to others in their industry.
By reviewing a company’s EBITDA, you can get a clearer picture of its value, particularly if you focus on comparing it to other businesses within a given sector. Although there is more to dive into concerning the benefits and drawbacks of using EBITDA when evaluating a potential investment, this information should give you a foundational understanding of this key metric.
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