We need to know the application of EBITDA & EBIT to arrive at a correct valuation of firms
When assessing the financial performance of their target investment firms, investors get stuck with two profit margins; namely, Earnings Before Interest and Tax (EBIT) and Earnings Before Interest Tax Depreciation and Amortization (EBITDA). Let us understand the meaning of these two margins along with their application in the investment context.
Let us assume the operating revenue of Trivikram Ltd (TL) in its recent financial year is Rs 1,500 crore ; other income is Rs 250 crore; raw material consumed is Rs 300 crore; purchase of stock in trade is Rs 100 crore; change in inventory of FG and WIP is Rs 20 crore; Depreciation and Amortization is Rs 200 crore; employee benefit expenses is Rs 200 crore; finance cost is Rs 80 crore and other expenses is Rs 200 crore.
EBITDA Margin (EBITDAM)
It is computed by dividing EBITDA by the operating revenue of a firm .Operating revenue refers to the portion of total revenue ( sum of operating revenue and other income)that is generated by a firm from its core operating activities while other income refers to the revenue generated by a firm from its non-operating activities such as revenue from investments in stocks and bonds of other firms and from the sale proceeds of investments. The operating revenue for TL is Rs 1,500 crore.
EBITDA is the excess of operating revenue over the operating expenses excluding depreciation and amortization (D&A) of a firm in a specific accounting period. In addition to D&A, we do not consider finance costs. Hence, operating expenses exclusive of D&A for TL is Rs 820 crore (sum of raw material consumed, purchase of stock in trade, change in inventory of FG and WIP, employee benefit expenses and other expenses).
EBITDA for TL is Rs 680 crore, i.e., Rs 1,500 crore less Rs 820 crore. Therefore, EBITDA margin is 45.33%, i.e., 680/1500 *100. This indicates that TL is earning EBITDA of Rs 45.33 for every Rs 100 of its operating revenue. EBITDA margin is applicable for firms with a significant amount of D&A in their P&L statement. It is quite useful in assessing the financials of firms operating in manufacturing and capital-intensive (higher proportion of tangible assets) sectors.
EBIT Margin (EBITM)
Also known as Operating Profit Margin (OPM), it is computed by dividing operating income (or EBIT) by operating revenue of a firm. EBIT can be computed by subtracting D&A from EBITDA profit figure. For TL it is Rs 480 crore, i.e., EBITDA of Rs 680 crore less D&A of Rs 200 crore. OPM for TL is 32%, i.e., 480/1500 *100. Thus TL is earning Rs 32 as operating profit for every Rs 100 of operating revenue. OPM or EBITM is to be computed for every firm irrespective of the sector in which it is operates.
Both EBIT & EBITDA profits are used vastly in valuation of firms. Hence, an understanding of their meaning and application is a pre-requisite in arriving at the value of the stocks for young investors.
The writer is associate professor, Finance, XLRI- Xavier School of Management, Jamshedpur