EBITDA is not profit

A friend forwarded an investor deck on Saturday, genuinely excited. EBITDA margin 28 percent. Trading at eight times EBITDA. Looks cheap, he said.

I asked him to scroll one slide down.

Past the EBITDA chart sits the actual profit and loss, and it tells a different story. EBITDA was 280 crore. Then came the lines the highlight slide leaves out. Depreciation of 150, which is the plants and machines wearing out and needing to be replaced. Interest of 90, the cost of the debt that bought those machines. Tax of 10. What reached the owner was 30 crore. A 28 percent margin on the slide became a 3 percent margin at the bottom.

EBITDA stands for earnings before interest, tax, depreciation and amortisation. Read that again. It is the profit before four of the largest bills a business actually pays. For an asset light software firm, those bills are small and EBITDA sits close to reality. For a capital heavy business, telecom, steel, cement, hotels, the depreciation and the interest are the business, and EBITDA is a number that quietly pretends the machines were free and the debt does not exist.

Here is the part that catches people. That cheap looking eight times EBITDA works out to about 41 times earnings once you count what EBITDA skipped. Same 280 of EBITDA, an asset light company keeps 68 rupees of every 100 as profit. The heavy one keeps 11. The gap between EBITDA and net profit is not noise. It is the cost of the assets and the debt, and for a heavy business it is the whole story.

So before you call a margin fat or a multiple cheap, read down to net profit, then check the cash. EBITDA is the profit a business would earn if the machines ran for free and the loan never came due. Neither is true.

Walk the slide down to the owner

Put the deck's numbers on one page so you can redo them with a pencil. Call it Company A. Revenue is Rs 1,000 crore. After raw material, staff and other running costs, EBITDA is Rs 280 crore, the 28 percent on the slide.

Now take the bills one at a time. Depreciation of Rs 150 crore leaves an operating profit (EBIT) of Rs 130 crore. Interest of Rs 90 crore leaves Rs 40 crore before tax. Tax of Rs 10 crore, about 25 percent, leaves Rs 30 crore of net profit. That is 3 percent of revenue, and 11 percent of the EBITDA the slide led with.

Depreciation is the line people wave away because no cheque is written for it this year. But the cheque was written earlier, when the plant was bought, and another one is coming when it wears out. A company that spends Rs 150 crore a year just to keep its machines running has not earned that Rs 150 crore in any sense its owner can use.

How eight times becomes 41 times

The two multiples measure different things, which is why both can be quoted with a straight face. EV to EBITDA compares the whole business, the shares plus the debt, with profit before every financing and asset bill. P/E compares only the shares with what is left for shareholders.

Here is the arithmetic. Eight times Rs 280 crore puts the enterprise value at Rs 2,240 crore. Suppose net debt is about Rs 1,010 crore, which fits the Rs 90 crore interest bill at roughly 9 percent. Take the debt out and the shares are worth about Rs 1,230 crore. Divide by Rs 30 crore of net profit and you get 41 times earnings. Same company, same day, same price.

Try it. Set depreciation to 25 and interest to 0, as an asset light business might have, and net debt to 0. Net profit jumps to about Rs 191 crore and the P/E falls to under 12. That is the 68 rupees in every 100 from the opening. The slide multiple did not change. What the owner gets for it did.

Light and heavy, same EBITDA

This is why EBITDA comparisons across sectors mislead so easily. Two companies with the same EBITDA margin can sit a world apart on net margin, because one owns its assets and the other rents brains. Within one sector, where every company needs the same kind of plant, EBITDA is a fair first screen. Across sectors it compares unlike things.

One more Indian wrinkle. Since 1 April 2019, Ind AS 116 has moved most lease rent out of operating costs and into depreciation and interest. A retailer or a hotel chain that rents its sites now shows a higher EBITDA for exactly the same business it ran before. Nothing about the shops changed. The rent just moved below the line the slide stops at.

Where to find the lines EBITDA skips

Every listed company files its results with NSE and BSE under SEBI's listing rules, and the statement of profit and loss in that filing shows each line separately. The deck is optional and written by the company. The filing is the one with a fixed format.

1. Depreciation and amortisationIts own line in the profit and loss. Compare it with capital spending in the cash flow statement: if capex runs well above depreciation year after year, the plant is still being built.
2. Finance costsThe interest line. Divide operating profit by it for interest cover; under 2 times leaves little room in a bad year.
3. TaxCurrent and deferred tax are shown apart. A tax rate far below the usual 25 percent deserves a look at the notes.
4. Cash from operationsIn the cash flow statement. Set it against net profit, not against EBITDA, to see what was collected.

The free Learn module on reading financial statements walks the profit and loss, the balance sheet and the cash flow statement line by line, with a quiz at the end. For the next step, the five lines below the headline shows how to strip one off gains, and other income takes apart the line that flatters profit from the other side.