The Uses of EBITDA

Jelly Roll Capital Equity Research

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Why Use EBITDA for Stock Screening?

I’ve received some questions about the methodology behind the compilation of our top 25 stocks list, as well as questions about the use of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) in analyzing investments. The two topics go hand-in-hand because EBITDA is one important criteria used in the screen, as I’ll explain.

EBITDA is a useful measurement for comparing companies because it excludes non-operational items that have no relation to the actual business, only to tax efficiency and financing decisions. In short, this means EBITDA excludes:
Interest Payments on debt, which is a function of whether or not a company chooses to finance itself through debt or equity. There are benefits and drawbacks to both forms, but because the payment on debt is a quantifiable number (whereas equity has no tangible cost) it is subtracted from operating income and the company receives a tax shield that lowers the overall tax rate.
Tax Efficiency. For many different reasons, certain companies have a tax rate that is lower than the commonly accepted corporate tax rate of 35%. A company may have operating loss carry-forwards (such as PALM), project-dependent reductions (ex., Aspreva for holding orphan drug status), or from the usage of offshore subsidiaries or tax shelters. Oftentimes the income boost from having a lower tax rate is in reality a temporary phenomenon, which is another reason for using EBITDA.
Depreciation and Amortization are non-cash charges related to the expensing of capital expenditures and intangible assets, respectively, over their useful life. Because companies have flexibility in how they recognize D&A, it is largely a matter of accounting preference. The so-called “double declining” depreciation recognition method lowers net income, which also reduces income taxes, and has the side effect of increasing cash flow because of the depreciation add-back. If this seems arbitrary, that’s because it is; on to an applied usage of EBITDA using Johnson & Johnson (JNJ, Stock Brief) and U.S. Tobacco (UST) as examples.

Enterprise Value/Net Income (FY2006)
UST: 20.18x
JNJ: 16.34x

Enterprise Value/EBITDA (FY2006)
UST: 11.09x
JNJ: 10.74x

How does UST look to be 25% more expensive than JNJ using net income, but is actually almost identical using EBITDA? UST has $840 million in debt and stockholders’ equity of $66 million; so the company is largely financed by debt, whereas JNJ has $2 billion in debt, but $39.3 billion in stockholders’ equity. This means that, although both companies pay approximately $60 million in interest on debt, that amounts to over 7% of Operating Income for UST but less than 1% for JNJ. This is one difference that is evened out by EBITDA, but seems important when looking at net income.

Looking at taxes, UST was subject to a 36% tax rate; JNJ had a tax rate of 24%. If JNJ had the same overall tax rate as UST, the company would have paid an additional $1.5 billion in taxes in FY2006, a highly material amount. In the future, the tax rate should rise back toward the 35% area, which could disappoint investors who are not aware of how temporary changes in a non-operational item like taxes effects net income.

The bottom line on EBITDA is that it is useful for comparing companies, although I wouldn’t necessarily recommend investors focus too heavily on it except to evaluate the possibility of a private equity acquisition and/or debt burden if a company is highly levered. EBITDA can be helpful, but I would recommend sticking with free cash flow for the actual valuation.