Profit can be hard to define. There are many metrics including operating profit, net profit, gross profit and more.
Investors tend to look for Earnings Before Interest Tax Depreciation Amortization (EBITDA). This is the net profit plus interest, taxes, depreciation and amortization.
EBITDA was first introduced in the mid-80s. It was a way for ‘leveraged buyout investors’ to assess distressed companies. If the interest payback on deals was good, then financial restructuring may take place.
But why is it important to them? Here’s a few reasons that EBITDA is the preferred choice:
EBITDA provides a better view of actual business health. And how well its business model is working
It removes capital investment and financing variables
It only accounts for necessary expenses for the day-to-day running of the business
It represents the cash flow generated by ongoing operations
It gives a good sign of how well the business is able to produce profits
It lets you compare how efficient a company is against its competitors
However, there are some issues to take into consideration. It’s worth taking a closer look at the interest, tax, depreciation and amortization figures. EBITDA contains depreciation and amortization. There’s an assumption that these types of expenses are avoidable. But we all know that they can’t be postponed forever. If you have manufacturing equipment it will at some points need replacing/upgraded.
For this reason, it’s a good idea to do a deep dive into these figures as well as a few others. Make sure no financial engineering is taking place – and be aware of some of its nuances:
It does not account for changes in working capital. Liquidity fluctuates because of interest, taxes and capital expenditures
There’s a need to assess the health of any tax implications and how these affect the figures
Check if there’s a high interest burden (maybe because of overleveraging). Interest in the EBITDA figure could make the company look as though it has more money to pay interest. The reality might be very different
Determine how difficult it would be to turn assets into cash. This could highlight low liquidity
Check to see if depreciation schedules have changed to inflate profit projections
Are there any other hidden charges? If so, you need to take these into account
There are other metrics you could look at. One example is EBITDA margin. This shows how operating expenses may be eating into the business’ profits. It can give an idea of the financial risk of the business.
It's important to look under the hood of any metric. Do your due diligence on a business’ audited books, particularly before you buy a business.
At the end of the day there’s no one way to value a company. Understand the pros and cons of particular methods you use. This will stand you on good ground to make better valuations and decisions.