When portfolio managers and analysts talk about stocks, they often praise or bemoan a company's Ebitda.
That's an accounting acronym and stands for earnings before interest, taxes, depreciation and amortization.
The somewhat complicated formula aims to get at something very simple: how much cash a business generates from operations.
One of the criticisms of Ebitda is that it excludes depreciation charges. Depreciation is a way of spreading the cost of big-ticket items like factories or machines over their productive life.
"It's the easiest profitability measure that approximates for cash flow," says Mark Haskins, professor of business at the University of Virginia's Darden School of Business. It is important to look at cash flow in addition to reported earnings because it offers a snapshot of the health of the heart of the business—specifically, how much money a company generates to do things like pay dividends.
There is a lot of muddiness around depreciation, says Prof. Haskins, partly because it is based on subjective judgments such as how long an asset will last. That is why some people want to ignore it. But others say depreciation is a real cost—machines inevitably will wear out and need to be replaced or upgraded—so it should be included in any good profitability measure.
When analyzing a company, you want to see growth in Ebitda as a result of increased revenue, not from financial engineering or from acquisitions, says Jack Ablin, chief investment officer of Harris Private Bank in Chicago.
Investors also like to see a big cushion of Ebitda versus interest costs.
"Ebitda of twice your interest costs is a comfortable ratio," says Mr. Ablin.
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