Earnings before Interest and Taxes, or EBIT, is a very common financial metric that many companies will use when they’re talking about the performance of their company, but the almighty question that we must answer is, what are the implications of it on your investments?
First, let’s dive a little bit more into what exactly earnings before interest and taxes means. In a quick summary, it’s a general measure of a company’s profitability. It’s also common to hear EBIT referred to as operating earnings/profit.
Chances are, you may have heard of EBITDA, which is the same formula except EBITDA contains Depreciation (D) and Amortization (A).
The formula for EBIT is very simple as shown below by Finance Strategists:
Let’s run through a quick example of calculating EBIT to help hammer it home a little bit more.
Sales/Revenue (32,184 Million) – Total Operating Expenses (25,023 Million) = $7,161 Million in EBIT
There are many pros and cons to using EBIT in your investing process but as with anything, it’s best that you learn from many different sources of information prior to making your decision on the topic. Let’s get started with the cons!
- EBIT is a non-GAAP metric
Personally, I think that this is by-far the biggest con when it comes to using EBIT as a metric. GAAP, or the generally accepted accounting practices, is a standard of accounting that is adapted by the SEC and by association, everything else isn’t considered to be a verified accounting number.
Because of this, there can always be a little bit of sneakiness that goes into any other number. Something that Cameron Smith talked about when talking about EBITDA was that when a company talks a ton about EBITDA rather than their net income, that should raise some skepticism and red flags to you as an investor
- EBIT doesn’t account for Depreciation and Amortization, unlike EBITDA
This can really come into play if you’re looking at companies that have varying capital assets and trying to compare them to one another. The company that has a lot of capital is going to be spending a lot of money in their upkeep of those assets, spending that they normally would depreciate and amortize, that they will not be able to do in the traditional EBIT metric.
- It can be easily misinterpreted
When using EBIT, you need to know what it is and what it is not if you want to make use of the metric. EBIT can be a great metric when looking at the operating income of the company as I will talk about later. But, if you’re using EBIT as the end all, be all for your proxy for net earnings, I highly encourage you to look at the true net income of the company.
There are just too many factors at play, most of all the fact that the reported EBIT is a non-GAAP metric.
- Can normalize operating income among companies
It’s inevitable that companies are never going to be in the same situation. They’re going to have varying revenues, taxes, interests, expenses, depreciation, amortizations, and many other items that you’re going to see broken out on the 10K. Having a common metric like EBIT is going to allow you to compare companies that are not very similar in a like vs. like manner.
This can be extremely important when one company has a lot of assets on the book. If a company has a ton of capital expenditures on their balance sheet, using EBITDA over EBIT is going to make their cash flow look much higher than it is.
EBIT is going to be able to siphon out those expenditures that are being marked as depreciations and amortizations and instead show them to you when the expense is occurring, which is likely what you want to see as an investor.
- It is a fantastic proxy for operating income and cash flow
I think that EBIT is a sound way to track the operating income of a company and unlike EBITDA, because it really is only including expenses and revenues that are occurring currently, you’re getting a real view into the balance sheet of the company.
While it does make a ton of sense for companies to depreciate their assets, the fact of the matter is that they’re paying for their capex on the front end, regardless of their depreciation or amortization schedule.
That money is physically leaving their pocket when those invoices come due, even if it’s a 7-year amortization period.
By not including any of the depreciation and amortization amounts in the calculation, you’re simplifying the process of comprehending cash operating cash flow.
Personally, I think that EBIT is a great metric and one that makes a lot of sense to be used, along with EBITDA, if you’re using it with context. You cannot substitute it for the net earnings of a company and expect that it’s a simple replacement.
Instead, use them for what they are as good metrics for understanding operating cash flow of companies.
And as always, it’s imperative that you’re comparing peers when evaluating these metrics just as you should with any other valuation metric. If you’re trying to look at an oil & gas company that has literally billions of dollars that they’re depreciating every single year and compare it to a cloud company, you’re going to be in trouble from the get-go, regardless if you use either EBIT or EBITDA.
EBITDA does seem to be much more common as a metric, so if you’re curious about that, we have three great articles from Andrew, Dave and Cameron! Check them out:
One way you’re going to exclude the depreciation and amortization and significantly hinder the oil company, while the other is going to make the oil & gas company look to have much better operating margin. You simply need to understand the metrics and apply them properly!
Just as you would do with other metrics you should do so with EBIT, especially those valuation metrics that everyone talks about lately as we’re seeing Price/Sales ratios get out of control! If you’re lost at the term, “valuation ratios”, don’t worry – we got you covered!