EBITDA removes the differences in profit arising on account of “newness” of assets or differences in Depreciation Method. 2 companies can be compared even if 1 follows SLM and the other WDV. If we used EBIT to compare an old airline company and a new airline company, the old one would appear more profitable (assuming both use WDV). This is because the old airline would have a much lower depreciation expense
NOTE: Never use EBITDA multiple to compare companies in different industries. An Airline Company with very high depreciation would have a high EBITDA multiple which is not comparable to the EBITDA multiple of a software company.
EBITDA multiple is preferred in valuations because you can take the EBITDA Multiple of listed entities in the same industry and value unlisted companies
The EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple is often considered better than the EBIT (Earnings Before Interest and Taxes) multiple in certain scenarios due to its ability to normalize earnings and provide a clearer picture of a company’s operating performance. Here’s an elaboration of the points mentioned in the summary:
Normalization of Earnings: EBITDA eliminates the impact of depreciation and amortization, which can vary based on factors like asset age or differing depreciation methods. This normalization allows for a more accurate comparison of operating profitability between companies. EBIT, on the other hand, includes depreciation and amortization, which can distort comparisons if different methods are used or if assets have varying ages.
Comparability: EBITDA enables more meaningful comparisons between companies, especially when they use different depreciation methods. For instance, one company might use the Straight-Line Method (SLM) for depreciation, while another uses the Written Down Value (WDV) method. Since EBITDA removes the impact of these methods, it is easier to assess their core operating performance.
Limitations of EBITDA: While EBITDA is useful for normalizing earnings, it’s important to note its limitations. EBITDA does not consider the effects of interest, taxes, and other non-operating expenses, which can vary significantly between companies and industries. As a result, EBITDA should not be used to compare companies in different industries or to assess a company’s ability to cover its debt obligations.
Industry Context: Comparing EBITDA multiples across different industries can be misleading. Industries with high levels of depreciation, like airlines, may have artificially high EBITDA multiples due to the removal of depreciation. This makes cross-industry EBITDA comparisons inappropriate and potentially misleading.
Valuation Benefit: EBITDA multiples are often preferred in valuation exercises, as they allow for a simpler and more direct comparison of companies within the same industry. Analysts can use EBITDA multiples of publicly listed companies in a specific industry to estimate the value of unlisted (private) companies in the same industry.
