Part 1, Lesson 10
In Part 1, Lesson 4, we introduced a commonly used accounting metric, EBITDA which stands for Earnings Before Interest Taxes Depreciation & Amortization. Below, we will discuss EBITDA in further detail and calculate EBITDA for Verizon.
Why is EBITDA so commonly used in accounting and finance and why is it important?
EBITDA is a well understood metric that allows for easy comparison of EBITDA margins and EBITDA multiples (more on this in Part 2 of this investment guide) across all businesses. While analysts and investors will likely not compare the absolute value of EBITDA between different companies, the comparison of EBITDA margins and multiples is a daily exercise in the investment world.
EBITDA incorporates all the expenses of the business except for three items: 1) interest, 2) taxes, 3) depreciation & amortization. Let’s go through an illustration of why this is important by comparing a hypothetical income statement for Company A and Company B:
Company A Company B Revenue $10,000 $10,000 EBITDA $5,000 $5,000 EBITDA Margin 50% 50% Depreciation & Amortization $1,000 $2,000 EBIT (Operating Income) $4,000 $3,000 EBIT Margin (Operating Margin) 40% 30% Interest Expense $2,000 $0 Earnings Before Taxes $2,000 $3,000 Tax Rate 40% 20% Taxes $800 $600 Net Income $1,200 $1,400 Net Income Margin 12% 14%
Looking at the above income statement, we can see that Company A and Company B (let’s assume they are in the same line of business) both have the exact same EBITDA margin of 50%. This would leave an observer of their income statement to conclude that both companies are comparable as far as their operational efficiency.
However, if an analyst were to use EBIT/operating margins as a basis for their comparison, the analyst would conclude that Company A is running their business more efficiently due to the higher operating margin. However, we’d have to dive into the drivers of depreciation for Company A vs. Company B to conclude that Company A is truly “running more efficiently.”
Differences in depreciation could simply be due to timing. Perhaps, Company B purchased a new piece of equipment this year, which had the effect of bumping its depreciation in the current year. Let’s assume Company A is also in the process of purchasing this equipment, but the purchase will occur next year at which point the Company A depreciation will catch up to Company B. If this were the story, it wouldn’t really be fair to say that Company A is really a higher margin business than Company B.
This brings up an important principle to always keep in mind – the numbers don’t always tell the complete story! When analyzing a financial statement, the numbers are equally as important as the background story.
Let’s continue with our comparison of Company A and Company B by looking at the net income margin. When comparing the net income margin, Company B has a higher margin vs. Company A. Can we now conclude that Company B is in fact the higher margin business? We would argue that the answer is not so simple.
Company B has $0 in interest expense, which means it has no debt. However, Company A is carrying more debt on its business as evidenced by its $2,000 interest expense payment. Why is there a difference in the level of debt and therefore interest expense between these two companies? The amount of financial leverage (debt) that a company takes on its usually a strategic decision made by the company management team. Some management teams are more comfortable with taking on high leverage, whereas other management teams may prefer lower leverage. Some companies may have access to better lenders, making it more attractive to take on debt vs. companies that don’t have good lending relationships.
Another big difference between the two companies is that Company A is paying a 40% tax rate, but Company B is paying a 20% tax rate. This could simply be due to Company A operating business in a higher tax jurisdiction vs. Company B which may be operating in a lower tax jurisdiction.
Company B does have a higher net income margin, but the lower financial leverage and the lower tax rate are large influencing factors on the net income margin.
Company A and Company B have the same EBITDA margin, Company A has a higher EBIT margin, and Company B has a higher net income margin. Which of these margins is most important to us as an investor?
As an investor, we want to pay attention to all of these margin metrics. However, if we are comparing margins between companies with the goal of drawing conclusions on operational efficiency, the EBITDA margin is often a better metric to look at since it is not influenced by non-operational decisions such as the tax rate or amount of financial leverage.
For example, if Company B had an EBITDA margin of 40% vs. Company A’s 50% margin. We could research if there are opportunities for Company B to improve its cost structure to reach Company A’s 50% margin level. On the other hand, if we were comparing net income margins between Company A and Company B, we’d need to eliminate differences in financial leverage, tax rates, and depreciation before we could draw proper conclusions on the cost structure of the operations of the business.
Although EBITDA is very commonly used, it is not a line item that appears in GAAP financial statements. However, many companies will proactively provide a calculation of EBITDA in their quarterly earnings press release to assist investors in arriving at the proper calculation of EBITDA for the company. Since EBITDA is so important for the valuation of a public company’s stock price, public companies will often “hand-hold” investors by calculating EBITDA so investors don’t make a mistake in their calculation of EBITDA.
Due to the common practice of companies presenting EBITDA in their press releases, it is important for investors to learn to calculate EBITDA independently and accurately. Public companies often exclude one-time items, stock-based compensation, or any item that they deem does not represent the go forward profitability of the business. It is our job as investors to verify the accuracy of EBITDA calculations presented by a public company.
Let’s return to Verizon’s income statement and calculate their 2016 and 2017 EBITDA. Below is the income statement for Verizon:
In the income statement, we have highlighted two of the key items we’ll need to calculate EBITDA: 1) operating income and 2) depreciation and amortization. In this case, the calculation of EBITDA is straightforward. All we’ll need to do is take operating income (EBIT) and add back the depreciation and amortization expense.
2017 2016 2015 EBIT $27,414 $27,059 $33,060 Plus: D&A $16,954 $15,928 $16,017 = EBITDA $44,368 $42,987 $49,077
That was easy enough. However, from looking at the income statement, Verizon has recognized a gain of $1,774 and $1,007 from the sale of divested businesses, which they have embedded into their SG&A cost. Recognizing a gain in the SG&A costs means that they have lowered the cost by the amount of the gain.
To arrive at a clean EBITDA figure, we should aim to eliminate one-time expenses or gains if those items truly do not reflect the ongoing operations of the business. Gains from the sale of a divested business certainly falls into that category, so we should adjust our EBITDA figure by removing these gains.
2017 2016 2015 EBIT $27,414 $27,059 $33,060 Plus: D&A $16,954 $15,928 $16,017 Less: One-time Gains $1,774 $1,007 $0 = EBITDA $42,594 $41,980 $49,077
Before moving on, let’s discuss two hot button items when it comes to the calculation of EBITDA:
Public companies and its investors continuously debate whether certain items are considered “one-time” in nature. In the ordinary course of business, every company will encounter costs (or revenue) that are atypically high (or atypically low), which may not reflect the true ongoing profitability of the business.
When these items occur and when these items are genuinely one-time in nature, investors will typically remove the one-time cost (or revenue) from its calculation of EBITDA and cash flow. However, the waters tend to get murky when companies present certain costs as one-time, but these one-time costs tend show up every year.
Let’s return to John’s Pizzeria. Let’s assume that John’s Pizzeria hired a manager, and this manager ends up working for the business for five years. At this time, John is faced with having to terminate this manager and pay a severance cost of $5,000 to this employee. As an investor in John’s Pizzeria, should we consider this $5,000 severance cost as one-time in nature? Given the relatively long length of employment (five years), it is reasonable to think that many investors would treat this as a one-time item. Not all investors may be so generous, but there is a good case to make that this is a one-time / non-recurring cost and should thus be excluded from EBITDA.
Now, let’s change the circumstances a bit. Let’s now assume that John’s Pizzeria hired a manager, and John, being a difficult owner or simply due to bad luck, terminates his manager and re-hires a new manager every year for the past five years. Each time John terminates his manager, he must pay severance cost of $5,000. Under this scenario, how should we treat the $5,000 severance cost?
In this case, it seems highly unlikely that investors will brush off the $5,000 severance cost as being one-time in nature since John is having to pay this cost regularly every year. As a practical matter, John may be able to eliminate this cost by keeping a manager on for a longer period of time, but given the history, investors would probably be reluctant to reward John’s Pizzeria by treating severance as one-time until John has proven that these costs are not recurring.
As we study public company financials, it is our job to parse through financial statements, financial statement notes, and management commentary to eliminate one-time costs and revenue so that we can having a better understanding of ongoing EBITDA levels.
Stock-Based Compensation (“SBC”)
One of the hot button controversies in accounting today is whether stock-based compensation should be considered an expense that should be included in EBITDA. Many companies, particularly companies in the technology sector, pay significant compensation to employees in the form of company stock options.
These stock options are given to align employees’ interests with that of the company and provide attractive upside optionality to employees if the company does well. In the hyper competitive employment market for technology jobs, pay packages involving stock-based compensation can be a significant piece of the cost structure for the business.
Given how costly these options can be, many companies present “EBITDA excluding stock-based compensation.” It is hard to argue that stock-based compensation (“SBC”) is one-time in nature. Instead, companies argue that the cost of the issuance of stock options manifests itself in the share count of the overall business. As stock is issued to employees, the increased share count of the business dilutes the earnings per share of the overall company. Therefore, companies may argue that you are double counting the cost of SBC by decreasing net income (the numerator) while simultaneously increasing the share count of the company (the denominator) when arriving at earnings per share.
Individuals who criticize the exclusion of SBC from EBITDA believe that SBC is a real and significant cost of doing business, and the modest dilution presented in the current year diluted share count does not adequately reflect the high cost of SBC.
Let’s look at the calculation of EBITDA for Twitter (TWTR) to get a sense for how significant stock-based compensation can be.
Calculating EBITDA for Twitter (TWTR)
Below is the final page of the fourth quarter 2017 earnings press release for TWTR, which details the company’s calculation for EBITDA.
In their calculation of EBITDA, TWTR starts with net income and then works backwards by adding back depreciation and amortization, interest expense, taxes, and one-time restructuring charges. Additionally, like many other tech companies, TWTR also adds back their stock-based compensation expense in their calculation of EBITDA.
Of significance here is the magnitude of the SBC vs. the EBITDA. In 2017, TWTR has calculated their EBITDA as $863 million. However, SBC accounts for $434 million which is half of the entire EBITDA amount. In other words, if we were to deduct the cost of SBC from EBITDA, the EBITDA for TWTR would drop 50% to $429 million.
When looking at the dilutive effect of stock option issuance, the diluted share calculation is only 1.2% higher than the basic share count. The dilution penalty to the share count is very modest (1.2%), whereas the reward for excluding SBC from EBITDA is very high (100% increase to EBITDA).
Unfortunately, as of today, there is no clear or easy answer for how to treat SBC going forward. Erring on the side of caution and conservatism may suggest that we should include SBC as a real cost of business when calculating EBITDA. However, it is also true that SBC is not a current cash outlay and should ultimately be reflected in the share count, so being too conservative on the treatment of SBC may cause investors to miss out on attractive long-term investments.
As we dive deeper into company valuations, it will be important to keep SBC top of mind, particularly for industries where SBC is a large portion of the cost structure.