One of the more popular metrics to take the financial community by storm over the last twenty years or so is the EBITDA margin, which companies use to determine their operating profitability. The EBITDA margin is a quick, easy way to determine the profitability of any company, but it does come with a little controversy.
If you read through any financial report these days, you will encounter the EBITDA acronym, but what does it actually mean, and how is it used to measure any profitability? EBITDA focus on the essentials of the business, operating profitability, and cash flow.
Using EBITDA margins also allows you to measure other companies in the same industry, which means you can compare operating profitability and cash flow to each company.
No analyst would argue the items such as depreciation, amortization, interest, or taxes are not important. Still, EBITDA strips all those numbers out and focuses on the cash flow and operating profitability of the company.
In today’s post, we will learn:
- What is the EBITDA margin?
- What Does the EBITDA Margin Tell Us?
- How to Calculate EBITDA Margin with Real Examples
- Do You Want a High or Low EBITDA Margin?
Ok, let’s dive and learn about the EBITDA margin.
What is EBITDA Margin?
Using the EBITDA margin is a quick way to assess a company’s operating profitability and cash flow. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization by total revenue.
The EBITDA margin is usually used to give business owners or investors a better idea of two things, operating profitability and cash flow, which is represented as a percentage of the business’s total revenue.
Unlike other metrics, the EBITDA margin takes a bird’s eye view of the current state of the company’s profitability and operations. Still, it avoids getting into the weeds of the individual line items of the income statement.
Earnings represented by the EBITDA margin comes from items such as cost of goods sold (COGS), and selling general and administrative (SG&A), but excludes depreciation and amortization.
Depreciation and amortization are the decreases in the value of goods or purchases over time, and the spreading out of loans over time as well. For example, if you buy a computer for your business, you are allowed to depreciate that expense over time as opposed to a one time charge if you choose. So instead of expensing that $1000 at one time, you can charge $100 every year for ten years until it is written off. The same idea applies to amortization with a loan; it can be written down over time.
How is EBITDA margin different from other profit margins such as gross profit, operating profit, or net profit? And why would we use EBITDA margin as opposed to the margins, as mentioned earlier?
Corporate accounting has a standard called generally accepted accounting principles or GAAP. These GAAP standards are requirements for corporate accounting. As an example, the EBITDA margin encompasses one of the three main principles for GAAP accounting by including gross profit margin, operating profit margin, and net profit margin.
For example, the net profit margin is one of the main ways a company uses GAAP metrics to evaluate whether or not the company can turn a profit based on its revenues or expenses.
GAAP principles standardize the three profit margins, and because of that, they are considered a good indicator of profitability and the financial health of a company.
But, the EBITDA margin operates on a different foundation, by using more nuanced metrics to help compare companies evaluate its health and performance. EBITDA doesn’t adhere to GAAP and is called a non-GAAP measure, and therefore EBITDA differs slightly from other profit margins such as net profit margin.
Also, EBITDA uses moderately different items to measure operational efficiency, as an example, unlike the earlier mentioned GAAP margins, EBITDA uses gross profit, which, for calculating EBITDA, is only consisting of the total revenue minus costs related to producing cost of goods for sale. And, operating profit includes depreciation and amortization, among other metrics.
Because of this reason, EBITDA is different from the operating margin because, unlike operating margin, EBITDA does include depreciation and amortization.
EBITDA margins are common in mergers and acquisitions of small companies and large corporations, mostly because it is an easy margin to calculate and compare different industries or different sizes of companies.
There are some pros and cons to the EBITDA margin; let’s explore them a little.
The EBITDA margin measures a company’s cash flows the company produces. And for many investors, using EBITDA is a better indicator than other profit margins because it reduces the importance of non-operating or other unique depreciation, amortization, and taxes.
Another pro is the ability to use EBITDA to compare companies across different industries because it compares operating profit to the total revenue as a percentage, which allows easier comparisons. The margin also allows investors to analyze how well a company is using its operating profits compared to its total revenue.
The EBITDA margin shows an investor or owner how well a company is using its resources and operating cash by showing the correlation between revenue and operating cash flow.
An additional bonus to using the EBITDA margin is the ability to track EBITDA margins over their years to track a companies progress. As well as compare their efficiency to other companies in their industry.
The main pro is the EBITDA margin allows owners, investors, or analysts to make more educated decisions about the business based on its operating income efficiency compared to the total revenue of the company.
Believe it or not, there are some cons to using the EBITDA margin to assess a company.
Some companies can use the EBITDA margin to mislead investors to make the company seem more profitable than it appears because EBITDA excludes any calculations regarding debt. Because of the higher debt levels, those companies will carry much higher interest payments, which erodes profitability.
Also, companies can appear more profitable with the addition of depreciation and amortization to their profit margin, which skews the numbers higher, which can be misleading to companies with low-profit margins to begin, which overestimates the profitability of the company.
Another con is the fact that EBITDA is a non-GAAP number, which means that some unethical companies may use the margin to mislead or misrepresent the true profitability of the company.
Even Forbes has denounced the metric, saying that it is misleading by indicating that asset-heavy companies are more profitable; it ignores debt, ignores working capital requirements, and lacks any GAAP guidelines.
Lastly, Warren Buffett and Charlie Munger have both denounced the metric, with Charlie referring to them as “b**s**” earnings.
For all the reasons listed above, both good and bad, it is best to use EBITDA alongside GAAP metrics to determine a business’s financial health.
What Does the EBITDA Margin Tell Us?
EBITDA helps investors and analysts determine short-term profitability and efficiency. The margin ignores the impacts of non-operating items such as taxes, interest expenses, and intangible assets. All of which contribute to a metric that provides a more accurate assessment of the company’s operating profitability. That is why many analysts and investors prefer EBITDA over other profitability metrics.
EBITDA is especially helpful in comparing companies with different debt, tax profiles, and capital investments.
It is also a preferred metric of earnings releases that are released quarterly and generally are not GAAP audited. For this reason, analysts prefer EBITDA because the metric ignores both taxes and interest expenses, which allows analysts to focus on the operational performance of the company.
Depreciation and amortization are non-cash expenses, which allow EBITDA to provide insight into operations that control capital expenditures, as well as cash generation. Profit margins measure income generation compared to the revenue that a company produces, and are used to measure the operational efficiency of the company.
EBITDA is also a useful tool in acquisitions because it focuses on the income and cash creation ability of the company, and EBITDA margins help determine the ability of an acquired company to fit with the new company.
Ok, now that we understand EBITDA and the pros and cons, let’s look at how to calculate this profitability margin.
How to Calculate the EBITDA Margin with Examples
The EBITDA margin is entirely calculated using numbers pulled directly from the income statement of any company; we can calculate it either quarterly or annually. I like to use the annual numbers, or the TTM, depending on where we are on the filing schedule.
For our first example, I would like to use Moody’s (MCO), the bond rating agency. The company is one of Warren Buffett’s investments and currently has a market price of $258.28 and a market cap of $48.43B.
The first step will be to look at the latest 10-k for Moody’s and highlight the numbers we need to calculate the margin.
The formula for the EBITDA margin is:
EBITDA Margin = EBITDA / Total Revenue
Where EBITDA stands for the following three line items:
- Total net revenues
- Depreciation and amortization
- Operating Income
A word of caution, not all companies will list operating income directly, so you might need to calculate that yourself which you can find directions here; it is also listed as EBIT or earnings before interest and taxes. Another note, all numbers will be in the millions unless otherwise stated.
Pulling out the highlighted sections of the income statement, we get:
- Revenues – $4,829
- Depreciation and Amortization – $200
- Operating Income – $1,998
Now to calculate our EBITDA margin with our formula.
EBITDA margin = EBITDA / Revenue
EBITDA Margin = Operating Income + Depreciation and Amortization / Revenue
EBITDA Margin = ($1,998 + $200) / $4,829
EBITDA Margin = 45.51%
That was pretty darn easy, let’s take a look at a few more.
Next, let’s take a look at Visa (V), which currently has a market price of $188.88 and a market cap of $414.89B.
Again I will look up Visa’s 10-k and highlight information for the company’s income statement for our calculations.
Now we will pull the numbers for our calculations from Visa’s income statement.
- Net revenues – $22,977
- Depreciation and Amortization – $656
- Operating Income – $15,001
Now let’s calculate our EBITDA margin.
EBITDA Margin = ($15,001 + $656 ) / $22,977
EBITDA Margin = 68.14%
For comparison’s sake, let’s look at the EBITDA margin for Visa from the previous year.
- Net Revenues – $20,609
- Depreciation and Amortization – $613
- Operating Income – $12,954
And now to find the EBITDA Margin for 2018.
EBITDA Margin = ($12,954 + $613) / $20,609
EBITDA Margin = 65.83%
Calculating EBITDA margins over multiple years is a great practice because it can help you see trends. When analyzing a company, it is a great practice to create a spreadsheet and put at least five years of metrics like EBITDA on the sheet so you can spot trends or isolate atypical years.
Let’s look at the EBITDA margin of some of the more popular companies out there.
- Facebook (FB) – 45.52%
- Amazon (AMZN) – 12.45%
- Apple (AAPL) – 30.61%
- Netflix (NFLX) – 60.09%
- Google (GOOG) – 30.96%
- Tesla (TSLA) – 11.12%
- Walmart (WMT) – 6.35%
- Target (TGT) – 8.19%
That’s a pretty decent cross-section of some of the bigger companies, including the FAANG stocks, which was interesting to see their performances.
Now let’s move on to the results and compare them across different sectors.
Do You Want a High or Low EBITDA Margin?
The above question is a pretty easy one to answer, the higher, the better. A low margin indicates a company that is struggling to maintain profitability and might have issues with cash flow.
A company that has a high EBITDA margin is stable, and the earnings are reliable.
A good EBITDA margin is one that is higher in comparison to its peers. Such as Target’s EBITDA margin was higher than Walmart’s, which indicates that Target is the more profitable company, at least for the last twelve months.
Here is a small listing of the industries with the highest and lowest EBITDA margins as of January 5, 2019.
- Green & Renewable Energy – 47.50%
- Utility (Water) – 45.98%
- REIT – 45.02%
- Railroads – 43.36%
- Semiconductor – 37.19%
- Oil & Gas – 35.31%
- Retail (General) – 6.50%
- Oilfield Services – 6.43%
- Engineering/Construction – 5.66%
- Healthcare Support Services – 5.04%
- Food Wholesalers – 4.28%
- Retail (Grocery and Food) – 4.21%
So comparing Walmart and Target to both the retail segments, general, and food, it appears that both are more profitable than the sector overall. Also, notice that Amazon, which was the lowest of the FAANG stocks, is also much higher than the general retail.
Along with comparing to others in their industry, it is also possible to use the profitability metric, such as the EBITDA margin across different companies as well. We can see that Facebook is far more profitable than Walmart, as is Visa, which was the most profitable of all the companies we analyzed today.
The EBITDA margin is another metric that we can add to our toolbox to help us find profitable companies that generate great cash flow. The metric is not difficult to calculate, and most companies provide you the information quite readily on their income statements.
You will notice the metric all over the earnings reports that each company releases every quarter, in part because it has become an accepted metric that everyone is familiar with using. But also because it falls outside of GAAP accounting and the 10-q reports are not required to be audited, and thus EBITDA is an acceptable acronym. It is far less common in the annual reports because those results are audited and follow GAAP accounting much more closely.
The EBITDA metric also has been used with Enterprise value, sales, as well as revenue. But the main goal of the EBITDA margin is to tell us quickly how profitable a company is, and how well they create cash flow. Some analysts use the EBITDA metric as a substitute for free cash flow when calculating intrinsic value, but I wouldn’t recommend that as it is flawed as an intrinsic value measurement because of the way that depreciation and amortization are treated. No one argues that those items are not a cash item, but rather how they should be treated. But the fact of the matter remains, it is a cash item paid out of the cash flow statement, which is a company’s checking account.
It is best to use the EBITDA margin along with other profitability margins to give you a true sense of the profitability of the company, and to avoid any overestimating the true worth of your company.
That is going to wrap up our discussion for today, as always, thank you for taking the time to read this post.
I hope you find some value in the post, and it helps you along your journey to becoming a better investor.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care and be safe out there,