EBITDA, which is often incorrectly confused with pretax earnings, is a measurement of a company’s earnings before interest, taxes, depreciation and amortization. This metric is often used by investors and brokers to select what they believe will be profitable stocks. By considering pretax earnings, and removing the other elements to reach EBITDA, profitable stocks may be chosen by making more accurate comparisons between competing companies.
Using EBITDA to Compare Stocks
One of the issues when comparing profitable stocks without using pretax earnings or EBITDA is that different companies may have different tax structures. EBITDA goes a step further than simple pretax earnings by removing other elements that may differ across companies, like capital structure, equipment leasing choices and others.
The idea is to get a more pure view of which companies will have profitable stocks by making comparisons in metrics that are more comparable. For example, if one were to only consider pretax earnings, equipment-intensive businesses might appear to have more profitable stocks because of large depreciation numbers. EBITDA removes this consideration.
Likewise, companies that carry large amounts of debt may appear to have less profitable stocks if only pretax earnings are used because of the high amount of interest that they must pay. Again, EBITDA removes this difference and allows for a more direct comparison to be made.
EBITDA Stock Analysis Shortcomings
When searching for profitable stocks, whether one uses pretax earnings, EBITDA, or some other metric, it is important to recognize the importance of the figures being excluded. Pretax earnings may be a more consistent comparison, but a company’s tax rate does affect its profitability. Profitable companies are likely to have profitable stocks, so it important to not blindly exclude material information from one’s analysis. This is particularly important when comparing companies from different industries.
Using metrics like EBITDA may hide important differences in different companies’ operations that may have a dramatic impact on the performance of the respective stocks. These metrics are a useful tool as long as they are used correctly.