The net profit reported by a company often carries noises that are driven by certain accounting and funding choices, which makes it very difficult to analyze a company. So, financial analysts focus on two other metrics: EBITDA and EBIT
While financial analysts understand the significance of these metrics, one common question that arises is which of the two metrics is better than the other. This is what we are going to answer in this article.
While we will not go deep into what is EBIT and EBITDA, let us briefly look at their meaning
EBIT: Refers to profit calculated before considering interest and tax expenses.
EBITDA: Refers to profit calculated before considering interest, tax, depreciation, and amortization expenses
So, the question about deciding which of the two is a better metric depends on whether depreciation and amortization is an expense worth considering or not.
So, why is that we do not want to consider depreciation? To understand this, let us look at a hypothetical case:
Let us suppose there are three companies: (i) Legacy enterprises (ii) NeoAgg and (iii) NeoCon. Let us assume that they are similar in all aspects except for the year of founding and the cost at which they acquired assets. Further, there is one small difference between NeoAgg and NeoCon: While NeoAgg has taken the estimated life of the property as 150 years, NeoCon expects the life to be 100 years.
Exhibit 1: Historical cost and estimated life of assets distort reported profits
As you can see in Exhibit 1, although the three companies own assets with the same economic value and have same level of business, their EBIT numbers are vastly different on account of two reasons:
(i) Depreciation calculation is based on historical cost and Legacy Enterprise has much lower depreciation because when they purchased the asset, the prices were much lower. Do note that the current market value of the asset is same as that of others
(ii) Even though NeoAgg and NeoCon bought the assets for the same price, NeoAgg is showing lower depreciation as their management is assuming a higher useful life.
In this case, we can clearly see the relatively lower EBIT number of NeoCon is not a reflection of the business performance.
Therefore, in this case, we may want to look at EBITDA to do a comparative evaluation of the business.
But is EBITDA always better?
Let us look at another case. Here we are talking about two web designing companies: ThriftDesign, and LavDesign.
Both the companies are almost the same, except that ThriftDesign chooses to use computers of lower prices and for as long as possible. LavDesign uses expensive computers and replaces them within a shorter time span while generating the same level of business as ThriftDeisng. The results of their operations are in Exhibit 2.
Exhibit 2: EBITDA ignores inefficiency in capex
As you can see in Exhibit 2, both the companies have same EBITDA. Even though we know that LavDesign has been relatively inefficient in its use of Capex, the inefficiency is not getting reflected in EBITDA.
This is an example where EBIT would be a better metric that captures the difference.
So, how do we generalize which metric is better?
Firstly, we need to realize that capital expenditures are an indispensable part of a business, and a true performance evaluation of a company should consider them.
And the profit and loss account item that reflects the capital expenditure is depreciation and amortization.
However, in the case of businesses where the weighted average life of assets is very high, the historical cost of assets, and thus depreciation, can be very different among various players, thus making it difficult to compare the performance. Therefore, EBITDA is a better metric for such companies.
If we want to oversimply this, we may say that EBITDA is a better metric for old economy businesses such as manufacturing enterprises.
If the average expected life of assets is not likely to be very high, then the difference in historical cost is not likely to be significant. In that case, it is better to look at EBIT.