Why Ebitda is not a good measure of profitability

Since the 1990s, the use of Ebitda (earnings before interest, taxes, depreciation and amortization) as a measure of profitability has gained popularity, being regarded by analysts and investors alike as a simple and straightforward metric for evaluating the operating profitability of a company.

The purpose of Ebitda is to offer a clearer view of the ability of a company to generate cash from its primary business activities.

While Ebitda highlights the core earnings, failure to account for these expenses results in an incomplete depiction of true cost structure and profitability. This limitation could potentially lead to misguided investment decisions.

For instance, interest expenses represent the cost of borrowed capital, and excluding them can distort the actual profitability, especially for highly leveraged companies.

Similarly, depreciation and amortization expenses reflect the gradual wear and tear of tangible and intangible assets, respectively. Failing to consider them can result in an inflated sense of profitability.

Take the case of Philweb. In its financial report for the first nine months of 2023, its Ebitda was P50.9 million, representing 8 percent of its total revenues. However, upon deducting its depreciation, interest, and income taxes, the bottom line results in a net loss of P13.6 million.

Ebitda is also often mistaken as a measure of cash flow because it ignores the cash flows associated with changes in working capital, which are important for assessing a company’s liquidity and long-term sustainability.

Cash flow dynamics

Changes in working capital, such as inventory levels, accounts receivable and accounts payable, impact a company’s cash flow and its ability to meet short-term obligations. By neglecting these factors, Ebitda fails to capture the cash flow dynamics that underpin financial stability.

For example, if we examine the financial report of Cebu Landmasters as of September 2023, its Ebitda stood at P4.7 billion, accounting for 36.5 percent of its total revenues. However, when we factor in the changes in its working capital, we find its operating cash flows for the period declining to negative P808 million.

READ: Using Ebitda multiple to buy stocks

Moreover, Ebitda is often used to see how easily a company can pay the interest of its outstanding debt in the form of Ebitda-to-interest coverage ratio. In reality, when a company has significant capital expenditures, it means that it needs to allocate a substantial amount of its cash flow toward these investments.

This allocation of cash reduces the available funds that the company can use for other purposes, such as debt service, which involves making interest payments on outstanding debt.

Even if the Ebitda-to-interest expense multiple of a company appears favorable, indicating that it generates enough earnings to cover its interest costs, neglecting the impact of capital expenditures can be misleading. The company may have limited cash available for debt service after accounting for the necessary investments in its operations.

Ignoring depreciation, interest expense

Investors rely on financial metrics like Ebitda to assess the attractiveness of a company for investment. When Ebitda fails to account for depreciation and interest expenses, investors may get the wrong impression that the company is more profitable than it actually is.

For example, PLDT has an enterprise value (EV) to Ebitda multiple of 5.1 times, which is lower than the market average of 7.9 times, indicating that it is relatively underpriced. But when we factor in the interest expenses and depreciation, PLDT appears overpriced compared with the market, with a price to earnings (P/E) ratio of 25.9 times, nearly double the market average of 13 times.

Capital-intensive companies often require substantial investments in infrastructure, equipment and technology to maintain operations and propel growth.

READ: Why investors should not use P/E ratio as a valuation tool

By ignoring depreciation, Ebitda fails to account for the ongoing capital requirements necessary to replace aging assets. As a result, investors may underestimate the future capital needs of the company, leading to underinvestment and potential operational challenges down the line.

Despite its flaws, Ebitda is still widely used and accepted in financial analysis because it’s easy to understand and calculate. It may seem like a simple and helpful metric for assessing performance, but it has significant limitations that make it unreliable. It is therefore important to be cautious and not rely solely on Ebitda when evaluating a company.

Investors and analysts should approach Ebitda with skepticism and consider other important factors like debt levels, tax exposures and asset depreciation to get a better understanding of the financial situation of a company. By understanding the limitations of Ebitda and considering a broader range of financial factors, investors can make more informed judgments and avoid being deceived by its apparent simplicity. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 106th RFP program this March 2024. To register, email [email protected] or text 0917-6248110.