What Is EBIT & EBITDA?
What is EBIT? What is EBITDA? Which is better to use and when? Why can’t I just use Net Income? All the answers... coming up!
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Net Income Is Not Enough
When you’re trying to figure out how profitable a company is, you might be tempted to just look at the bottom of its income statement, its Net Income. Logical—but that number is not super helpful when attempting to value a company. The reason for that is because there are several “expenses” that come out before the bottom line that aren’t truly representative of the company’s current performance.
A better place, where many successful investors look, is a little higher up on the statement. It’s called EBIT, or Earnings Before Interest and Taxes. This is Net Income exclusive of the company’s interest expense and taxes.
The reason that’s valuable is because neither of these exclusions represent the company’s current performance. The interest they pay has to do with past financing terms. And the taxes a company pays vary based on geography (...and the mad-tax skills of their accountants). So removing both of those offers a clearer picture of current income.
Wall Street likes to stretch this idea even further with EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
An argument can be made for not including a company’s depreciation expenses because they represent the historical investment decisions a company has made, not current performance. Especially for capital-intensive industries—like telecom or oil and gas—this metric could prove more useful.
Buffett's take on EBITDA
Even though EBITDA is an industry norm and commonly used, a counterpoint from Warren Buffett should be considered. He plainly observes, "In respect to EBITDA: depreciation is an expense; it's the worst kind of expense." [emphasis added]
So, if you choose to use EBITDA for your analysis (as many successful investors do), to respect Buffett’s point, be sure to at least specifically evaluate and compare the depreciation expenses of the company you’re researching, because it does still have a major impact.
EBIT > Net Income
So now you know: Net Income, we love you, but you’re not giving us the full picture. It’s not until you add back the taxes and interest (and maybe the depreciation) that you can really use these numbers (and ratios derived from these numbers) to compare different companies.
We’ll definitely be exploring some of those ratios and additional metrics you can use as you build your rapidly-growing, highly-diversified net worth, so stay tuned!