NEW YORK (CNN/Money) -
EBITDA. Like most acronyms, it sounds slightly scary. And thanks to WorldCom's accounting woes, EBITDA is now one of the most fear-inducing words (or acronyms) on Wall Street.
For most companies, earnings is the be-all, end-all measure of profitability. A company sells stuff (gets revenue), then pays all its expenses (from manufacturing costs to interest payments to taxes). Also included in expenses are depreciation and amortization, the gradual expensing of assets over time.
What's left after subtracting all that is earnings, or net income -- the "bottom line."
But for some companies, investors use EBITDA, or earnings before interest, taxes, depreciation and amortization. It's the metric for dozens of other companies mostly involved with wireless, cable or media. What they have in common is huge capital investments that depreciate -- and detract from stated earnings.
In addition, they all share a new suspicion from investors, now that WorldCom revealed that it inflated EBITDA by classifying $3.8 billion in normal expenses as capital expenditures.
Is EBITDA getting a bad rap?
Because of their big investments, cable and media companies tend to post losses for years on end. But that alone doesn't make them worthless -- EBITDA is a way of judging how their assets are performing now.
"EBITDA is particularly useful when you have companies with big capital investments, heavy up-front costs where it takes a while to get returns back," says Chuck Hill, director of research for First Call.
* As of June 28 | Source: FirstCall |
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Take a look at Cox Communications. It is widely regarded as one of the best-run cable companies. But it lost 74 cents a share last year, is expected to lose 22 cents a share this year and another 13 cents a share in 2003.
Based on net income alone, probably no sane investor would buy the stock. But Cox's EBITDA was $2.61 a share last year and the company is expected to earn $2.90 this year and $3.30 in 2003, indicating that the company investments are generating a return.
Even so, the indicator isn't perfect. Though the WorldCom-inspired distrust doesn't make much sense (after all, WorldCom's fraud says little about other EBITDA companies), investors should be careful when using it. Here are a few things to consider:
- The ultimate goal is still profitability. It is one thing to look at EBITDA closely when a company is not making money, says Hill. But once a company is profitable by generally accepted accounting principles (GAAP), he thinks that should supercede EBITDA.
- Be careful when assessing value. Comcast, for example, is trading at just 6.7 times 2002 EBITDA estimates. But that's not directly comparable to a company with a P/E of 6.7. In fact, Comcast seems pricey compared to competitors Charter Communications and Cablevision, which trade at 1.4 and 1.9 times 2002 EBITDA, respectively. What's more, Comcast is profitable, with estimated earnings per share for 2002 of 78 cents -- for a P/E of 28.
- EBITDA can mask balance sheet problems. A company with a big debt load will also have high interest expenses, an issue that won't show up in EBITDA. "EBITDA can often lead you down the wrong path. Interest is an obligation that you have to meet," Hill says.
- Don't confuse it with free cash flow. Many investors use the two measures interchangeably, a big mistake. Free cash flow also backs out amortization and depreciation charges, but not interest expenses and taxes.
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