As beginners learning how and where to invest money in Singapore, you would have heard that there are two type of investors: fundamental and technical. Technical investors often given no regard to the underlying business. Instead, they often look at market price movement, often making predictions about future price changes through the interpretation of historic price changes. Fundamental investors on the other hand often hold no regard for price movements and like to look at the value of the company. One good example will be Warren Buffett who has made the art of value investing renowned.
When looking at the fundamental value of a company, one will definitely come across two terms, EBIT and EBITDA. EBIT is short hand for Earnings before Interest and taxes whereas EBITDA is Earnings before interest, taxes and depreciation.
Why EBIT/EBITDA is core to fundamental analysis
EBIT/EBITDA is core to fundamental analysis because this type of analysis evaluates the earnings of the company in any given year. When used for discounted cash flow analysis, EBIT/EBITDA can be used to calculate the value of the entire firm which is also known as the enterprise value.
How to calcualte EBIT and EBITDA and why is it useful
EBIT is commonly calculated as :
Net Profit + Taxes + Interest
On the other hand, EBITDA is derived from adding depreciation and amortisation to the EBIT number. The net profit, taxes and interest number can be obtained from the income statement whereas the depreciation and amortisation amount is most commonly found in the cash flow statement.
EBIT and EBITDA can be analysed as a margin. An EBIT of $20 from a topline revenue of $100 will give an EBIT margin of 20%. As a rule of thumb, a higher margin within the same industry is often a signal of a more profitable business. That said, there are ways to legally adjust the EBIT numbers to make it look higher.
Why EBIT/EBITDA and not Net Profit
Those who have dug into an income statement would have realised that many companies report net profit instead of EBIT or EBITDA. Given that Net Profit is a readily available number, why is there a need to spend the additional effort to calculate EBIT or EBITDA?
The reason is because EBIT and EBITDA are capital structure agnostic. What this means is that EBIT and EBITDA do not consider the effects of the company borrowing money to fund its operations. In so doing, it makes for easier comparison for companies in the same company but with different capital structure. For example, Company A has $1000 in revenue, $ 500 in operating cost and $200 in interest. Company B has $800 in revenue, $500 in operating cost with no borrowings. In such a situation, just solely relying on net profit will make Company B seem the same as Company A as both has $ 300 in net profit. However, looking at the EBIT margin will show that Company A has EBIT margin of 50% whereas the second company has a margin of 37.5%. Hence, calculating EBIT does allow us to understand a little more about the true earning potential of the business.
Similar to how EBIT helps investors to be capital structure agnostic, EBITDA helps investors to momentarily ignore the effects of depreciation and amortization which is a non cash expense.
Using EBIT to get to enterprise value
While knowing a firm has high Earnings Margin can mean it is a good buy, what price should you acquire shares of the company at? A good business need not be a good investment if bought at too high a price. From the fundamental investor perspective, it is possible to get an intrinsic value of the company by looking at the cash flow from the company. Hence, if we assume that the company can generate $100 in EBIT every year, we can calculate the present value of this stream of cash flow. This present value divided by the number of shares outstanding then gives us the intrinsic value per share for the business.
This is by far not an exhaustive explanation of how to use EBIT and EBITDA in fundamental analysis. However, it should be a helpful introduction to those who are starting to learn the art.