In accounting, EBITDA stands for "Earnings before Interest, Taxes, Depreciation, and Amortization". Which as the name suggests is earnings excluding expenses from depreciation, amortization, interest, and taxes (earnings + ITDA), in the way the usually appear on the income statement, up to down. It's the operating income plus depreciation and amortization.

When companies publish their financial statements, the most important metric for investors is the company's income, which is calculated as the company's revenue minus all its expenses. Some companies also publish their EBITDA, which, these companies usually claim, provides a more true picture of the company's profitability than the "income" number.

Depreciation

Specifically, a company's "income" number is always distorted by decisions that the company made in previous years. Depreciation of capital expenditures is a particularly strong factor. For example, if a company spends $99 million in new desktop computers for all its employees, the company will often decide to depreciate the purchase over three years. This way, in the first year, when the company calculates its "income" number, it pretends that it has only spent $33 million that year on desktop computers. The company's income number paints a more rosy and optimistic picture than actually occurred that year. In each of the second and third years, the company also pretends that it has spent $33 million per year on desktop computers. Hence, the company's financial picture was probably healthier than indicated by the income number, since the $33 million had actually already been paid out.

The EBITDA number, it is claimed, does not suffer from this distortion in the second and third years, so investors can get a better idea of how profitable the company really is. Some purchases are depreciated or amortized over 20 years or more, with a negative impact on the business's "income" number long after the actual financial effects of the purchases have ceased.

Critics include Warren Buffett, who famously asked, "Does management think the tooth fairy pays for capital expenditures?" Hypothetically, a company could spend a trillion dollars on capital expenditures, and this would never show up in the next million years of the company's EBITDA reports. The "income" number is therefore a more true picture, say critics of EBITDA reporting, and if an investor wishes to examine short-term financial performance, he should examine the "operating cash flow" numbers.

The Sophisticated Investor's Perspective on EBITDA

Three fundamental issues underly the use of EBITDA vs. other measures in assessing the value of a firm.

The first is that a company's capital expenditures are typically variable. In addition, companies depreciate or amortize the capital expense over a varable number of years. In order to generate more tax revenue governments typically force companies to spread a capital expenditure over the life of the item purchased. This prevents a company from having a zero tax bill if it reinvests all of its profit in capital expenditures. EBITDA removes the variable effects from the income measure. A professional investor can use EBITDA to approximate the fundamental earning power of the company's operations while separately factoring in the projected capital expenditures needed to maintain those operations. This is valuable because of the time value of money. A sophisticated investor knows that a large capital expenditure is less costly if it is to be made several years into the future (because during the interim period the firm can use the cash for that expenditure to generate income in other ways). Therefore the sophisticated investor looks at a "pure" measure of ongoing earnings-generating potential and then makes an educated assessment of the timing of significant capital expenditures.

The second issue is that the value of a company's equity differs depending on its capital structure (whether and to what extent the company is financed with debt). Because EBITDA is also an earnings measure before interest and taxes (which vary with the amount of debt financing), it approximates the company's earnings potential if financed with no debt. If capital structure is the only concern (rather than timing of capital expenditures), then EBIT can be used. A professional investor that can contemplate changing the capital structure of a firm (e.g., through a leveraged buyout) first evaluates a firm's fundamental earnings potential (reflected by EBITDA or EBIT), and then determines the optimal use of debt vs. equity.

The third issue is that the owner of a firm's equity receives all of the cash flows generated by the firm after meeting all of the firm's commitments. This is the company's free cash flow. Before factoring in capital expenses, this is the company's operating cash flow. Cash flow measures include the impact of changes in the company's balance sheet, and in that way differ from income measures. For example, if a company must purchase an increasingly large amount of inventory as its sales grow, then the company will typically use cash to buy that inventory before receiving cash in return from customers. The company faces costs as a result of this use of cash: it either gives up the profits it could have earned by using that cash elsewhere (e.g., by investing it in an income-producing security) or decreases returns to equity holders by issuing additional debt or equity. This use of cash reduces the company's cash flow, and reduces the value of the firm, but has no effect on income. EBITDA is not useful in assessing the impact of such changes in the company's balance sheet.

Historical Context

Most dot-com companies attempted to promote their stock by means of emphasizing either EBITDA or pro forma earnings in their financial reports, and explaining away the (often poor) "income" number. In the United States, the Securities and Exchange Commission has cautioned companies that they will be charged with fraud if they use these alternative numbers in order to mislead investors.