WEBVTT 00:00:00.000 --> 00:00:01.679 Welcome back to the Deep Dive. I want you to 00:00:01.679 --> 00:00:05.040 just picture a scene for a moment. Okay. You've 00:00:05.040 --> 00:00:07.419 just walked into a high -stakes meeting. Could 00:00:07.419 --> 00:00:09.519 be a boardroom, could be, you know, one of those 00:00:09.519 --> 00:00:12.099 Zoom calls with investors who have those very 00:00:12.099 --> 00:00:13.919 expensive -looking bookshelves. No, I know the 00:00:13.919 --> 00:00:16.500 ones. The curated ones. Exactly. Yeah. And you're 00:00:16.500 --> 00:00:18.879 feeling good. You've done your reading. But then 00:00:18.879 --> 00:00:21.039 the conversation starts, and it's like English 00:00:21.039 --> 00:00:24.820 just leaves the room. There's a definite shift, 00:00:25.019 --> 00:00:28.019 isn't there? It is a palpable shift. Yeah. People 00:00:28.019 --> 00:00:31.239 stop using normal words like, profit or, you 00:00:31.239 --> 00:00:34.560 know, spending, they start talking in code. It's 00:00:34.560 --> 00:00:37.539 the alphabet soup. It is the alphabet soup. Someone 00:00:37.539 --> 00:00:39.539 asks about the ROI. Someone else pivots to the 00:00:39.539 --> 00:00:42.420 CAGR. And then the person at the head of the 00:00:42.420 --> 00:00:46.500 table with a very serious face asks, but what's 00:00:46.500 --> 00:00:49.039 the EBITDA looking like compared to the ROE? 00:00:49.299 --> 00:00:51.420 Right. And if you don't know the secret handshake, 00:00:51.539 --> 00:00:53.659 if you don't know the code, you just sort of 00:00:53.659 --> 00:00:56.259 sit there nodding. Hoping nobody asks you a direct 00:00:56.259 --> 00:00:59.079 question. Exactly. Hoping they don't call on 00:00:59.079 --> 00:01:02.200 you. It can feel incredibly exclusionary. I mean, 00:01:02.200 --> 00:01:04.760 it's designed to be precise. I get that. But 00:01:04.760 --> 00:01:06.340 a lot of the time it just functions as a kind 00:01:06.340 --> 00:01:09.400 of date keeping. It does. It separates the money 00:01:09.400 --> 00:01:12.920 people from the, you know, the operational people. 00:01:13.319 --> 00:01:15.920 It feels like they're guarding a temple. But 00:01:15.920 --> 00:01:18.799 today we are going to kick down the door of that 00:01:18.799 --> 00:01:21.790 temple. We're going to grab a spoon and we're 00:01:21.790 --> 00:01:24.469 going to eat that alphabet soup. I'm in. And 00:01:24.469 --> 00:01:27.370 we are focusing on, I think, arguably the most 00:01:27.370 --> 00:01:31.129 important acronym in that entire bowl. If you 00:01:31.129 --> 00:01:33.049 really want to understand the true horsepower 00:01:33.049 --> 00:01:36.370 of a business, not the accounting tricks, not 00:01:36.370 --> 00:01:38.930 the tax strategies, but the actual machine itself, 00:01:39.250 --> 00:01:43.030 you need to understand one thing. EBIT. E -B 00:01:43.030 --> 00:01:46.280 -I -T. Earnings before interest and taxes. It's 00:01:46.280 --> 00:01:48.200 a classic for a reason. And I love that you use 00:01:48.200 --> 00:01:50.099 the word horsepower. That is exactly the right 00:01:50.099 --> 00:01:52.439 way to think about it. So let's lay out the mission 00:01:52.439 --> 00:01:54.219 for this deep dive. We're not just going to, 00:01:54.219 --> 00:01:56.040 you know, read a definition from a textbook and 00:01:56.040 --> 00:01:57.620 move on. No, we're going to tear this thing apart. 00:01:57.879 --> 00:02:00.439 We are. We've pulled together a serious stack 00:02:00.439 --> 00:02:02.859 of sources for this. We have financial definitions 00:02:02.859 --> 00:02:06.900 from Nasdaq, some really good deep dive explainers 00:02:06.900 --> 00:02:09.740 from Investopedia, and we're leaning very heavily 00:02:09.740 --> 00:02:12.020 on what is, I mean, it's basically the Bible 00:02:12.020 --> 00:02:14.379 of investment theory, Essentials of Investments 00:02:14.379 --> 00:02:18.409 by Boddy, Kane, and Marcus. That text is absolutely 00:02:18.409 --> 00:02:21.270 essential. It frames EBIT not just as a line 00:02:21.270 --> 00:02:24.330 on a spreadsheet, but as a real tool for making 00:02:24.330 --> 00:02:26.710 decisions. And to make this real, we're not just 00:02:26.710 --> 00:02:29.189 going to talk theory. We have a specific statement 00:02:29.189 --> 00:02:31.030 of income from the source material. We're going 00:02:31.030 --> 00:02:33.530 to go through it line by line. We are going to 00:02:33.530 --> 00:02:36.090 track every single dollar from the moment it 00:02:36.090 --> 00:02:38.840 enters the company as revenue. all the way down 00:02:38.840 --> 00:02:41.780 until it lands, or what's left of it lands, in 00:02:41.780 --> 00:02:43.659 a shareholder's pocket. And that walkthrough 00:02:43.659 --> 00:02:45.180 is going to be so critical because that's where 00:02:45.180 --> 00:02:47.759 the story is. That's where the money hides. You 00:02:47.759 --> 00:02:50.479 can talk theory all day, but until you see exactly 00:02:50.479 --> 00:02:52.539 where the expenses get deducted, it's all just 00:02:52.539 --> 00:02:55.159 abstract. Right. And by the end of this, I want 00:02:55.159 --> 00:02:58.680 you, our listener, to go from maybe vaguely recognizing 00:02:58.680 --> 00:03:02.900 the term EBIT to thinking like a, well, a ruthless 00:03:02.900 --> 00:03:05.580 professional investor. I like it. We want you 00:03:05.580 --> 00:03:08.219 to be able to look at a company. and just mentally 00:03:08.219 --> 00:03:10.800 strip away all the baggage to see what the core 00:03:10.800 --> 00:03:14.020 of it is actually worth. So let's start with 00:03:14.020 --> 00:03:16.800 that big picture, the why should I care question. 00:03:17.500 --> 00:03:19.680 Why are we so obsessed with earnings before we 00:03:19.680 --> 00:03:21.740 pay the bills? It's a really valid question. 00:03:21.860 --> 00:03:23.759 I mean, in your personal life, you don't really 00:03:23.759 --> 00:03:26.280 care about your earnings before mortgage and 00:03:26.280 --> 00:03:28.580 taxes. Not at all. You care about what hits your 00:03:28.580 --> 00:03:30.120 checking account, right? What you can actually 00:03:30.120 --> 00:03:32.900 spend. Yeah. If I go to my bank and say, hey, 00:03:32.960 --> 00:03:36.180 listen, my personal EBIT is huge. I just happen 00:03:36.180 --> 00:03:38.139 to have a lot of credit card debt. They're still 00:03:38.139 --> 00:03:40.840 going to foreclose on my house. Exactly. In personal 00:03:40.840 --> 00:03:45.129 finance, cash is king. End of story. But in corporate 00:03:45.129 --> 00:03:47.310 finance, especially when you're analyzing the 00:03:47.310 --> 00:03:50.030 quality of a business, looking at the bottom 00:03:50.030 --> 00:03:52.650 line, the net income can actually be a trap. 00:03:52.810 --> 00:03:55.909 A trap. How so? Isn't that the final score? It's 00:03:55.909 --> 00:03:57.949 the final score for the tax man, yes. And it's 00:03:57.949 --> 00:03:59.930 the final score for the current shareholders. 00:04:00.289 --> 00:04:02.409 Right. But it doesn't tell you how well the team 00:04:02.409 --> 00:04:04.789 is actually playing the game. Okay. I like that 00:04:04.789 --> 00:04:07.789 analogy. Let me try one. Imagine you're a scout 00:04:07.789 --> 00:04:10.169 and you're looking for a marathon runner. Got 00:04:10.169 --> 00:04:13.400 it. You've got two runners. Runner A runs a mile 00:04:13.400 --> 00:04:16.300 in six minutes. Runner B runs a mile in eight 00:04:16.300 --> 00:04:18.939 minutes. On paper, it's an easy choice. Signed 00:04:18.939 --> 00:04:21.519 Runner A. No -brainer. But then you look a little 00:04:21.519 --> 00:04:23.839 closer, and you see that Runner B is carrying 00:04:23.839 --> 00:04:28.220 a 50 -pound backpack full of rocks. Oh. And not 00:04:28.220 --> 00:04:32.250 only that, Runner B is running uphill. in a thunderstorm 00:04:32.250 --> 00:04:36.050 and runner a runner a is on a flat dry track 00:04:36.050 --> 00:04:38.449 with a nice tailwind okay the context changes 00:04:38.449 --> 00:04:41.209 everything everything that backpack is debt the 00:04:41.209 --> 00:04:43.449 interest payments are the weight that's dragging 00:04:43.449 --> 00:04:46.550 that runner down and that thunderstorm that's 00:04:46.550 --> 00:04:49.970 a high tax jurisdiction maybe a runner b operates 00:04:49.970 --> 00:04:53.029 in a country with a 40 corporate tax rate while 00:04:53.029 --> 00:04:55.670 runner a is set up in a tax haven if you just 00:04:55.670 --> 00:04:57.949 look at the finish time the net income you'd 00:04:57.949 --> 00:05:00.689 say runner b is slow and you'd walk away but 00:05:00.689 --> 00:05:02.689 you be wrong. You'd be totally wrong. Because 00:05:02.689 --> 00:05:05.089 if you strip away the backpack, the interest, 00:05:05.269 --> 00:05:07.269 and you strip away the bad weather, the taxes, 00:05:07.350 --> 00:05:09.689 you might find that runner B is actually a four 00:05:09.689 --> 00:05:12.290 minute miler just waiting to be unleashed. And 00:05:12.290 --> 00:05:14.730 that is what EBIT does. It takes the backpack 00:05:14.730 --> 00:05:17.860 off. Precisely. It allows you to evaluate what 00:05:17.860 --> 00:05:20.240 the source calls the fundamental earnings potential 00:05:20.240 --> 00:05:24.060 of the firm. It's separate from how it's financed 00:05:24.060 --> 00:05:26.300 and separate from where it pays its taxes. It's 00:05:26.300 --> 00:05:28.720 the raw athletic ability of the company. I want 00:05:28.720 --> 00:05:30.920 to stick with this professional investor persona 00:05:30.920 --> 00:05:34.399 for a second because our source material explicitly 00:05:34.399 --> 00:05:37.560 mentions this character. Right. It's an investor 00:05:37.560 --> 00:05:41.939 who's contemplating a change to the capital structure. 00:05:42.879 --> 00:05:45.750 Now that sounds fancy. What does it actually 00:05:45.750 --> 00:05:48.269 mean in plain English? Capital structure is just 00:05:48.269 --> 00:05:50.490 a fancy way of asking whose money are we using 00:05:50.490 --> 00:05:52.209 to run this business? Okay. Are we using our 00:05:52.209 --> 00:05:54.649 own money, which is equity, or are we using other 00:05:54.649 --> 00:05:57.449 people's money, which is debt? So borrowing from 00:05:57.449 --> 00:05:59.389 a bank versus selling shares in the company. 00:05:59.529 --> 00:06:01.490 That's it. Now put on your private equity shark 00:06:01.490 --> 00:06:03.829 hat for a second. Okay. Shark hat on. You're 00:06:03.829 --> 00:06:06.290 hunting for a company to buy. You find a business 00:06:06.290 --> 00:06:08.850 that looks a lot like our runner B. It has a 00:06:08.850 --> 00:06:11.629 terrible net income. It's barely making a profit 00:06:11.629 --> 00:06:13.610 on paper. Most investors would just walk right 00:06:13.610 --> 00:06:16.459 by. But not me. Not with my shark hat on. Not 00:06:16.459 --> 00:06:18.939 you. Because you, the professional, you look 00:06:18.939 --> 00:06:21.319 past the bottom line and you look at the EBIT. 00:06:21.459 --> 00:06:24.319 You see that the business itself, the core operation, 00:06:24.459 --> 00:06:27.079 is actually making millions. So where's the money 00:06:27.079 --> 00:06:29.930 going? It's all being spent paying the interest 00:06:29.930 --> 00:06:32.310 on some terrible loan that a previous manager 00:06:32.310 --> 00:06:35.329 took out 10 years ago. It's that 50 pound backpack. 00:06:35.569 --> 00:06:37.470 So you see an opportunity there. You see a massive 00:06:37.470 --> 00:06:40.050 opportunity. You say, I can fix this. So you 00:06:40.050 --> 00:06:42.310 go in, you buy the company, you pay off that 00:06:42.310 --> 00:06:44.970 bad debt. Maybe you refinance it at a much lower 00:06:44.970 --> 00:06:46.709 rate. You get rid of the backpack. You get rid 00:06:46.709 --> 00:06:48.930 of the backpack. And suddenly those millions 00:06:48.930 --> 00:06:50.930 of dollars that were going straight to the bank 00:06:50.930 --> 00:06:54.389 are now flowing into your pocket as profit. And 00:06:54.389 --> 00:06:56.389 you haven't changed the product. You haven't 00:06:56.389 --> 00:06:59.050 fired a single salesperson. All you did was change 00:06:59.050 --> 00:07:00.750 the capital structure. But you never would have 00:07:00.750 --> 00:07:02.730 seen that opportunity if you only looked at net 00:07:02.730 --> 00:07:06.009 income. Never. Which is why the source emphasizes 00:07:06.009 --> 00:07:09.089 that two -step evaluation process. Step one, 00:07:09.310 --> 00:07:11.790 evaluate the fundamental earnings potential. 00:07:12.269 --> 00:07:16.329 That's EBIT. Step two is then, and only then, 00:07:16.509 --> 00:07:19.129 you determine the optimal use of debt versus 00:07:19.129 --> 00:07:21.610 equity. You have to keep them separate. You have 00:07:21.610 --> 00:07:24.040 to. You can't judge the quality of an engine 00:07:24.040 --> 00:07:25.860 if you're distracted by the current price of 00:07:25.860 --> 00:07:28.879 gas. Step one is checking the engine. That's 00:07:28.879 --> 00:07:32.240 EVIT. Step two is deciding how much gas to put 00:07:32.240 --> 00:07:34.339 in the tank. That's the debt decision. If you 00:07:34.339 --> 00:07:36.620 mix those two up, you make very bad investments. 00:07:37.060 --> 00:07:40.259 Okay, I think we have sold the why. It is a god 00:07:40.259 --> 00:07:42.459 mode of investing. It lets you see through the 00:07:42.459 --> 00:07:46.079 matrix. Now let's get into the what. Section 00:07:46.079 --> 00:07:48.680 one of our outline is defining this core concept. 00:07:49.100 --> 00:07:51.399 Based on the sources, let's get the absolute 00:07:51.399 --> 00:07:54.560 plain English definition. What is EBIT? At its 00:07:54.560 --> 00:07:57.240 most basic, most fundamental level, EBIT is a 00:07:57.240 --> 00:07:59.459 measure of a firm's profit that includes all 00:07:59.459 --> 00:08:01.879 incomes and all expenses. All of them? Almost. 00:08:02.060 --> 00:08:04.500 It takes that big pile of revenue from the top 00:08:04.500 --> 00:08:07.230 and it subtracts nearly everything. But... and 00:08:07.230 --> 00:08:08.589 this is what we can call the great exclusion, 00:08:08.910 --> 00:08:12.370 it stops right before it pays two very specific 00:08:12.370 --> 00:08:14.889 entities. The great exclusion. I like that. Who 00:08:14.889 --> 00:08:17.129 gets left out of the party? It excludes interest 00:08:17.129 --> 00:08:19.910 expenses, so the bankers and bondholders, and 00:08:19.910 --> 00:08:22.449 it excludes income tax expenses, so the government. 00:08:22.730 --> 00:08:24.910 Hence the name, earnings before interest and 00:08:24.910 --> 00:08:27.149 taxes. It's right there on the tin. It sounds 00:08:27.149 --> 00:08:31.009 so simple, but I know there are traps here. One 00:08:31.009 --> 00:08:32.470 thing I found really interesting in the source 00:08:32.470 --> 00:08:35.450 material was the clarification about non -operating 00:08:35.450 --> 00:08:38.370 items. I think a lot of people, myself included 00:08:38.370 --> 00:08:41.389 sometimes, assume EBIT just means profit from 00:08:41.389 --> 00:08:44.009 selling widgets. That is probably the most common 00:08:44.009 --> 00:08:47.070 misconception. People immediately confuse EBIT 00:08:47.070 --> 00:08:49.809 with operating profit. They think, oh, it's just 00:08:49.809 --> 00:08:51.909 the money that's made from the day -to -day core 00:08:51.909 --> 00:08:55.389 business. But the source is very specific about 00:08:55.389 --> 00:08:58.929 this nuance. EBIT includes all income. So give 00:08:58.929 --> 00:09:00.950 me an example. What's an income source that isn't 00:09:00.950 --> 00:09:03.049 from the core business? Okay, let's say you run 00:09:03.049 --> 00:09:05.629 a bakery. Your core business is selling croissants 00:09:05.629 --> 00:09:08.399 and coffee. The money you make from that, that's 00:09:08.399 --> 00:09:10.480 your operating income. Makes sense. But let's 00:09:10.480 --> 00:09:12.440 say the bakery also happens to own the building 00:09:12.440 --> 00:09:14.639 it's in, and you rent out the apartment that's 00:09:14.639 --> 00:09:17.399 on the second floor. Okay. That rent money you 00:09:17.399 --> 00:09:20.399 collect every month is income, for sure. But 00:09:20.399 --> 00:09:22.759 it has absolutely nothing to do with bacon croissants. 00:09:22.799 --> 00:09:26.039 That is non -operating income. Or what if the 00:09:26.039 --> 00:09:28.620 bakery had a big pile of cash from a good year 00:09:28.620 --> 00:09:30.460 and it's just sitting in a savings account earning 00:09:30.460 --> 00:09:33.700 2 % interest? Exactly. That interest income you're 00:09:33.700 --> 00:09:36.740 earning is non -operating. Now here's the absolute 00:09:36.740 --> 00:09:40.240 key. EBIT. includes that rent money from the 00:09:40.240 --> 00:09:42.559 apartment. It includes that interest income from 00:09:42.559 --> 00:09:44.919 the bank account. It's meant to capture the total 00:09:44.919 --> 00:09:47.500 earnings of the entire entity before you pay 00:09:47.500 --> 00:09:49.539 your own interest on debt and your taxes to the 00:09:49.539 --> 00:09:52.659 government. So if I'm a baker and I sell a million 00:09:52.659 --> 00:09:55.080 dollars worth of croissants, but I also happen 00:09:55.080 --> 00:09:57.600 to make a million dollars day trading GameStop. 00:09:58.110 --> 00:09:59.970 with the company's bank account. Then your EBIT 00:09:59.970 --> 00:10:02.830 is $2 million. Wow. And that is why you have 00:10:02.830 --> 00:10:04.809 to be so careful. Because if you're an investor 00:10:04.809 --> 00:10:06.870 just glancing at that bakery, you might think, 00:10:06.950 --> 00:10:08.870 wow, those must be some incredibly profitable 00:10:08.870 --> 00:10:11.590 croissants. But in reality, half your profit 00:10:11.590 --> 00:10:13.990 is coming from, you know, gambling on mean stocks. 00:10:14.730 --> 00:10:16.750 This brings us perfectly to the synonym confusion 00:10:16.750 --> 00:10:19.289 part of our outline. I see people use the terms 00:10:19.289 --> 00:10:22.110 EBIT and operating income interchangeably all 00:10:22.110 --> 00:10:24.320 the time. Even on financial news sites. Are they 00:10:24.320 --> 00:10:27.500 just wrong? They're imprecise. Let's call it 00:10:27.500 --> 00:10:30.299 that. The source material gives us a very strict, 00:10:30.460 --> 00:10:33.299 almost mathematical condition here. It says that 00:10:33.299 --> 00:10:35.659 EBIT and operating income are sometimes used 00:10:35.659 --> 00:10:38.960 as synonyms. Sometimes. But they are only, and 00:10:38.960 --> 00:10:42.580 I mean only, synonyms if the firm has zero non 00:10:42.580 --> 00:10:45.360 -operating income and zero non -operating expenses. 00:10:45.700 --> 00:10:50.019 Which seems pretty rare for... Any company of 00:10:50.019 --> 00:10:52.840 a certain size. In the real world, it's incredibly 00:10:52.840 --> 00:10:55.559 rare for a large company. I mean, almost every 00:10:55.559 --> 00:10:58.679 major corporation has some side investments or 00:10:58.679 --> 00:11:01.940 maybe a one time gain from selling an old factory 00:11:01.940 --> 00:11:04.940 or a lawsuit settlement or some currency exchange 00:11:04.940 --> 00:11:08.379 gains. Anything. Anything. The moment a company 00:11:08.379 --> 00:11:11.019 has even one single dollar of non -operating 00:11:11.019 --> 00:11:13.779 income or expense, EBIT and operating income 00:11:13.779 --> 00:11:16.100 are no longer the same number. They drift apart. 00:11:16.519 --> 00:11:19.299 So going back to our bakery, if I have zero side 00:11:19.299 --> 00:11:22.139 hustles, if I just bake and sell, my operating 00:11:22.139 --> 00:11:25.179 income is my EBIT. Correct. But the very moment 00:11:25.179 --> 00:11:27.340 I rent out that upstairs apartment for the first 00:11:27.340 --> 00:11:29.399 time. Their EBIT becomes higher than your operating 00:11:29.399 --> 00:11:32.389 income. And why does this distinction matter 00:11:32.389 --> 00:11:34.570 so much? It matters because of valuation, what 00:11:34.570 --> 00:11:36.350 we talked about before. If you're an investor 00:11:36.350 --> 00:11:38.309 and you apply a multiple to the company's earnings 00:11:38.309 --> 00:11:40.389 to guess what the whole company is worth, you 00:11:40.389 --> 00:11:41.769 need to know if those earnings are sustainable. 00:11:42.220 --> 00:11:44.740 Is that EBIT coming from selling croissants year 00:11:44.740 --> 00:11:47.360 after year, which is sustainable? Or is it coming 00:11:47.360 --> 00:11:49.820 from a one -time sale of the company's delivery 00:11:49.820 --> 00:11:53.259 van? A one -off event. Exactly. Both of those 00:11:53.259 --> 00:11:55.919 things show up in EBIT. But only the profit from 00:11:55.919 --> 00:11:57.679 the croissants shows up in operating income. 00:11:57.919 --> 00:12:00.159 It's like saying cash on hand is the same as 00:12:00.159 --> 00:12:03.309 salary. I guess for a kid with a paper route, 00:12:03.429 --> 00:12:05.570 maybe it is. But for an adult who might have 00:12:05.570 --> 00:12:08.509 just sold a car or gotten an inheritance, cash 00:12:08.509 --> 00:12:10.889 on hand is a very, very different number from 00:12:10.889 --> 00:12:13.649 their weekly salary. That is a perfect analogy. 00:12:14.529 --> 00:12:16.870 Complexity breaks the synonym. The bigger and 00:12:16.870 --> 00:12:19.350 more complex the company, the less likely it 00:12:19.350 --> 00:12:20.970 is that those two numbers are going to be the 00:12:20.970 --> 00:12:23.830 same. Okay, let's move on. Section three, the 00:12:23.830 --> 00:12:26.879 formulas. We know what it is. We know why we 00:12:26.879 --> 00:12:29.019 want it. Now, how do we actually calculate it? 00:12:29.059 --> 00:12:31.679 The source offers a few different paths to get 00:12:31.679 --> 00:12:33.919 to the truth. Let's start with method A, the 00:12:33.919 --> 00:12:35.980 top -down approach. The top -down approach is 00:12:35.980 --> 00:12:38.080 the most intuitive way, I think. You're just 00:12:38.080 --> 00:12:39.879 following the flow of the money as it comes into 00:12:39.879 --> 00:12:41.679 the business. You start at the top of the waterfall. 00:12:42.039 --> 00:12:44.480 Exactly. You start at the very top of the income 00:12:44.480 --> 00:12:47.419 statement with revenue, the big number, the sales. 00:12:47.700 --> 00:12:49.480 And then you just start chipping away. You start 00:12:49.480 --> 00:12:52.559 chipping away. First, you subtract the cost of 00:12:52.559 --> 00:12:55.340 goods sold. So for our bakery, that's the flour, 00:12:55.480 --> 00:12:58.299 the sugar, the direct labor of the bakers. Okay. 00:12:58.379 --> 00:13:00.320 Then you subtract all the operating expenses, 00:13:00.440 --> 00:13:02.600 the rent for the shop, the marketing budget, 00:13:02.740 --> 00:13:05.679 the CEO salary, all of that stuff. And if I just 00:13:05.679 --> 00:13:09.000 stop right there, after subtracting all of that. 00:13:09.080 --> 00:13:11.399 If you stop there, you've calculated operating 00:13:11.399 --> 00:13:15.269 income. Not EBIT. Not EBIT. To get all the way 00:13:15.269 --> 00:13:18.090 to EBIT, you have to remember to then adjust 00:13:18.090 --> 00:13:20.429 for any of that non -operating stuff we just 00:13:20.429 --> 00:13:23.009 talked about. Add any non -operating income. 00:13:23.590 --> 00:13:27.009 Subtract any non -operating expenses. But fundamentally, 00:13:27.210 --> 00:13:30.409 the top -down method is revenue minus all your 00:13:30.409 --> 00:13:33.129 expenses except for interest and taxes. It feels 00:13:33.129 --> 00:13:34.850 like the honest way to do it. You really see 00:13:34.850 --> 00:13:36.909 where all the money went. But I have to admit, 00:13:37.049 --> 00:13:39.509 I'm a big fan of method B, the bottom -up approach. 00:13:39.710 --> 00:13:42.149 It feels a bit more like detective work. It's 00:13:42.149 --> 00:13:43.850 often the faster way to do it, especially if 00:13:43.850 --> 00:13:45.490 you're just skimming a financial report and you 00:13:45.490 --> 00:13:47.389 don't want to go through line by line. You just 00:13:47.389 --> 00:13:49.090 jump straight to the end of the story. You go 00:13:49.090 --> 00:13:50.710 straight to the bottom line. You look at net 00:13:50.710 --> 00:13:53.429 income. This is the number after the massacre, 00:13:53.549 --> 00:13:56.129 right? After the bank has taken its cut, after 00:13:56.129 --> 00:13:59.029 the IRS has taken its huge cut. This is the number 00:13:59.029 --> 00:14:01.929 for the survivors. The survivors. And then you 00:14:01.929 --> 00:14:04.629 basically resurrect the dead. You take that net 00:14:04.629 --> 00:14:06.750 income number and you add the taxes back in. 00:14:06.990 --> 00:14:09.549 Then you add the interest payments back in. The 00:14:09.549 --> 00:14:14.590 formula being? Ebit equals net income plus interest 00:14:14.590 --> 00:14:17.509 plus taxes. Exactly. It's reverse engineering. 00:14:17.649 --> 00:14:19.970 It's saying, OK, I see what you have left at 00:14:19.970 --> 00:14:21.570 the end of the day. Now let me see what you would 00:14:21.570 --> 00:14:23.649 have had if you didn't have these two very specific 00:14:23.649 --> 00:14:26.409 obligations. Is one method better than the other? 00:14:26.509 --> 00:14:29.110 Do they always give the same answer? Mathematically, 00:14:29.230 --> 00:14:31.769 they have to equal the exact same number. If 00:14:31.769 --> 00:14:34.909 they don't, then someone is cooking the books. 00:14:35.470 --> 00:14:37.990 But practically speaking, the top -down method 00:14:37.990 --> 00:14:39.889 is much better for understanding the business 00:14:39.889 --> 00:14:42.629 model. You get to see the profit margins at every 00:14:42.629 --> 00:14:45.230 single step of the process. The bottom -up method 00:14:45.230 --> 00:14:47.450 is better for understanding the capital structure's 00:14:47.450 --> 00:14:49.769 impact because you are physically seeing how 00:14:49.769 --> 00:14:51.970 much cash was taken out by those interest payments. 00:14:52.269 --> 00:14:54.250 There is a third method mentioned in the source 00:14:54.250 --> 00:14:56.950 material, the EBITDA bridge. We haven't fully 00:14:56.950 --> 00:15:00.629 introduced EBITDA yet, but it's EBIT's louder, 00:15:00.750 --> 00:15:04.110 more famous cousin. Right. EBITDA is... Earnings 00:15:04.110 --> 00:15:07.009 before interest, taxes, depreciation, and amortization. 00:15:07.769 --> 00:15:10.330 It's an even rougher or purer number, depending 00:15:10.330 --> 00:15:12.750 on your point of view. It's much closer to a 00:15:12.750 --> 00:15:15.210 raw cash flow metric. So if I have the EBITDA 00:15:15.210 --> 00:15:17.590 number, how do I use that to get to EBIT? It's 00:15:17.590 --> 00:15:19.830 simple. You just subtract the D and the A. You 00:15:19.830 --> 00:15:22.029 take EBITDA and you subtract depreciation and 00:15:22.029 --> 00:15:24.250 you subtract amortization. But why would I want 00:15:24.250 --> 00:15:26.049 to do that? Why not just stick with EBITDA? I 00:15:26.049 --> 00:15:27.929 hear that term all the time. Because machines 00:15:27.929 --> 00:15:30.929 break. Ovens rust. Computers become obsolete. 00:15:32.049 --> 00:15:33.830 Depreciation isn't just some accounting trick. 00:15:33.990 --> 00:15:36.789 It represents the very real wear and tear on 00:15:36.789 --> 00:15:39.610 your company's physical assets. It's a real cost, 00:15:39.750 --> 00:15:41.490 even if you don't write a check for it this year. 00:15:41.570 --> 00:15:44.049 It's a very real cost. If you run a trucking 00:15:44.049 --> 00:15:46.409 company, your trucks are physically wearing out 00:15:46.409 --> 00:15:49.230 every day. If you ignore depreciation and just 00:15:49.230 --> 00:15:51.230 use EBITDA, you're basically pretending your 00:15:51.230 --> 00:15:53.259 trucks will last forever. They won't. Which they 00:15:53.259 --> 00:15:55.820 won't. If you use EBIT, you're acknowledging 00:15:55.820 --> 00:15:57.759 the reality that eventually you're going to have 00:15:57.759 --> 00:16:01.919 to spend real cash to buy new trucks. So EBIT 00:16:01.919 --> 00:16:05.059 is cleaner than net income because it ignores 00:16:05.059 --> 00:16:08.440 the financing and tax decisions. Right. But it's 00:16:08.440 --> 00:16:12.019 dirtier or maybe more realistic than EBITDA because 00:16:12.019 --> 00:16:14.559 it acknowledges the physical reality of your 00:16:14.559 --> 00:16:17.419 assets degrading over time. Exactly. You can 00:16:17.419 --> 00:16:20.019 think of EBIT as sitting in this perfect Goldilocks 00:16:20.019 --> 00:16:22.759 zone. It ignores the money stuff, the interest 00:16:22.759 --> 00:16:25.460 in taxes, but it respects the physical stuff, 00:16:25.500 --> 00:16:28.480 the depreciation. Okay. Now we are going to do 00:16:28.480 --> 00:16:30.899 something we don't often do. We're going to do 00:16:30.899 --> 00:16:33.360 some math on a podcast. I'm ready. But don't 00:16:33.360 --> 00:16:36.360 panic. We are going to walk through the deep 00:16:36.360 --> 00:16:38.799 dive calculation from Section 4 of our outline. 00:16:39.440 --> 00:16:41.740 We have a specific statement of income pulled 00:16:41.740 --> 00:16:44.120 from our source. I want you to visualize this. 00:16:44.379 --> 00:16:47.600 Imagine a spreadsheet, or even better, imagine 00:16:47.600 --> 00:16:50.340 a big stack of cash sitting on a table. Let's 00:16:50.340 --> 00:16:53.000 do it. The source gives us figures in thousands, 00:16:53.179 --> 00:16:55.399 but let's just use the numbers as they are for 00:16:55.399 --> 00:16:57.679 simplicity. Yeah. At the very, very top of the 00:16:57.679 --> 00:16:59.620 pile, we have sales revenue. The starting rate. 00:16:59.759 --> 00:17:04.000 And the number is $20 ,438. Set in there. That 00:17:04.000 --> 00:17:06.240 is our total potential. That is every dollar 00:17:06.240 --> 00:17:08.619 that customers handed over for our product or 00:17:08.619 --> 00:17:11.059 service. Now, the very first hand reaches into 00:17:11.059 --> 00:17:14.279 that pile. This is the cost of goods sold or 00:17:14.279 --> 00:17:17.180 KGS. This is the raw cost of actually making 00:17:17.180 --> 00:17:19.630 the stuff we sold. In our example, this takes 00:17:19.630 --> 00:17:23.670 away $7 ,943. Wow. Okay. So that's almost 40 00:17:23.670 --> 00:17:26.230 % of our revenue gone instantly. This covers 00:17:26.230 --> 00:17:28.450 the direct labor, the raw materials, the cost 00:17:28.450 --> 00:17:30.769 to run the factory. If this number is too high 00:17:30.769 --> 00:17:33.450 relative to revenue, nothing else down the line 00:17:33.450 --> 00:17:37.049 even matters. So we take our $20 ,438. We subtract 00:17:37.049 --> 00:17:40.869 that $7 ,943. We're left with a subtotal called 00:17:40.869 --> 00:17:44.799 growth profit. And that number is $12 ,495. Okay, 00:17:44.839 --> 00:17:46.359 so we still have more than half of our money 00:17:46.359 --> 00:17:48.279 left. The business looks fundamentally healthy 00:17:48.279 --> 00:17:52.039 so far. But now comes the messy middle. The operating 00:17:52.039 --> 00:17:53.920 expenses. This is where the overhead and the 00:17:53.920 --> 00:17:56.220 bloat can hide. Let's list the items that are 00:17:56.220 --> 00:17:58.799 eating away at our pile of cash. First up, the 00:17:58.799 --> 00:18:01.480 big one. Selling, general, and administrative 00:18:01.480 --> 00:18:05.700 expenses. SG &A. This is usually the biggest 00:18:05.700 --> 00:18:08.079 bucket of miscellaneous costs. It's your marketing 00:18:08.079 --> 00:18:10.160 department, your sales commissions, HR team, 00:18:10.359 --> 00:18:12.420 the legal department, the rent on your corporate 00:18:12.420 --> 00:18:14.660 headquarters. The whole works. The whole works. 00:18:14.799 --> 00:18:18.180 And in our example, this eats up $8 ,172. Well, 00:18:18.220 --> 00:18:20.720 wait a second. Hold on. We had just under $12 00:18:20.720 --> 00:18:24.019 ,500 in gross profit, and we just spent over 00:18:24.019 --> 00:18:27.609 $8 ,000 on admin. That feels like a lot. It is 00:18:27.609 --> 00:18:29.789 a lot. And as an investor, that is the very first 00:18:29.789 --> 00:18:31.690 line I would circle with a red pen. Why does 00:18:31.690 --> 00:18:33.490 it cost us over eight grand to support selling 00:18:33.490 --> 00:18:36.230 20 grand worth of goods? Is the CEO flying on 00:18:36.230 --> 00:18:38.569 private jets? Are we spending way too much on 00:18:38.569 --> 00:18:41.109 Super Bowl ads? This line item is where efficiency 00:18:41.109 --> 00:18:43.470 lives or dies. OK, so our pile is shrinking really 00:18:43.470 --> 00:18:46.670 fast. What's next? Next up is depreciation and 00:18:46.670 --> 00:18:51.089 amortization. This line item is $960. Now, this 00:18:51.089 --> 00:18:52.630 is an interesting one. Did we actually write 00:18:52.630 --> 00:18:55.799 a check to someone for $960 this year? No. And 00:18:55.799 --> 00:18:57.900 that's the key distinction. This is a non -cash 00:18:57.900 --> 00:19:00.380 expense. We didn't actually pay anyone. The cash 00:19:00.380 --> 00:19:03.500 is still technically in the building. We just, 00:19:03.619 --> 00:19:05.819 on paper, admitted that our factory equipment 00:19:05.819 --> 00:19:09.019 and other assets lost $960 worth of value this 00:19:09.019 --> 00:19:11.579 year. So it reduces our profit for tax purposes, 00:19:11.839 --> 00:19:13.960 but it doesn't reduce our cash in hand. For this 00:19:13.960 --> 00:19:15.400 period, that's right. And finally, there's a 00:19:15.400 --> 00:19:19.299 small line item for other expenses at $138. So 00:19:19.299 --> 00:19:21.579 if we add all those up, our total operating expenses 00:19:21.579 --> 00:19:25.940 are $9 ,270. A big number. very big number. So 00:19:25.940 --> 00:19:27.779 we subtract that from our gross profit. What 00:19:27.779 --> 00:19:29.819 are we left with? We are now left with operating 00:19:29.819 --> 00:19:35.900 profit. The math is $12 ,495 minus $9 ,207. That 00:19:35.900 --> 00:19:39.099 gives us a grand total of $3 ,225. Okay, stop 00:19:39.099 --> 00:19:42.420 the tape right there. $3 ,225. Is this our EBIT? 00:19:42.420 --> 00:19:44.819 Have we arrived? Not quite yet. And this is the 00:19:44.819 --> 00:19:47.259 exact moment where that synonym confusion we 00:19:47.259 --> 00:19:49.079 talked about earlier gets resolved in the real 00:19:49.079 --> 00:19:52.329 world. Why isn't this EBIT? We've subtracted 00:19:52.329 --> 00:19:54.009 all the operating costs. It's called operating 00:19:54.009 --> 00:19:56.250 profit. Because if you look closely at the income 00:19:56.250 --> 00:19:58.329 statement from our source, there is one more 00:19:58.329 --> 00:20:00.849 specific line item just below the operating line. 00:20:00.910 --> 00:20:05.369 It says non -operating income of $130. Ah, there 00:20:05.369 --> 00:20:07.450 it is. The side hustle. The apartment rental. 00:20:07.609 --> 00:20:10.890 Exactly. Maybe this company sold off an old patent, 00:20:11.009 --> 00:20:13.029 or they had some cash sitting in a high -yield 00:20:13.029 --> 00:20:14.650 savings account that paid them some interest. 00:20:15.109 --> 00:20:18.269 That $130 is real profit, but it's not operating 00:20:18.269 --> 00:20:20.369 profit, however. It is part of earnings before 00:20:20.369 --> 00:20:22.809 interest and taxes. It absolutely is. So we have 00:20:22.809 --> 00:20:25.049 to add it back in. We take our operating profit 00:20:25.049 --> 00:20:29.589 of $3 ,225, and we add that $130 of non -operating 00:20:29.589 --> 00:20:34.819 income. And now, the reveal. EBIT is $3 ,355. 00:20:35.140 --> 00:20:36.420 I'm going to pause on this for a second. This 00:20:36.420 --> 00:20:38.160 is so important. The operating profit was $3 00:20:38.160 --> 00:20:41.630 ,225. The EBIT is 3355. They're different numbers. 00:20:41.849 --> 00:20:44.269 They are. And look, in this specific example, 00:20:44.490 --> 00:20:47.509 the difference is pretty small, only $130. But 00:20:47.509 --> 00:20:49.829 imagine if that non -operating income line was 00:20:49.829 --> 00:20:52.730 $3 ,000 because the company sold a massive piece 00:20:52.730 --> 00:20:55.369 of land it wasn't using. Then EBIT would be almost 00:20:55.369 --> 00:20:58.210 double the operating profit. Exactly. And if 00:20:58.210 --> 00:21:00.549 you, as an investor, just looked at that big 00:21:00.549 --> 00:21:02.990 EBIT number, you might think the core business 00:21:02.990 --> 00:21:05.750 was absolutely booming. But the core business, 00:21:05.990 --> 00:21:08.130 the operating profit, hasn't changed at all. 00:21:08.480 --> 00:21:10.700 This is why you always have to read the footnotes 00:21:10.700 --> 00:21:13.000 in a financial report. You have to. OK, so we 00:21:13.000 --> 00:21:17.259 have our core number. EBIT is $3 ,355. This is 00:21:17.259 --> 00:21:19.319 the horsepower. This is what the machine itself 00:21:19.319 --> 00:21:21.579 actually generated this year. But we're not done. 00:21:21.740 --> 00:21:24.000 The stack of cash is about to get raided by those 00:21:24.000 --> 00:21:26.380 two entities we excluded earlier. Right. We were 00:21:26.380 --> 00:21:28.900 at earnings before interest and taxes. So now 00:21:28.900 --> 00:21:30.940 it's time to handle the interest and the taxes. 00:21:31.200 --> 00:21:33.759 The income statement in the source first lists 00:21:33.759 --> 00:21:37.359 financial income of $45. We add that in. That 00:21:37.359 --> 00:21:39.299 brings us to a little subtotal called income 00:21:39.299 --> 00:21:43.380 before interest expense, IBE, of $3 ,400. This 00:21:43.380 --> 00:21:45.019 is getting granular, I know, but bear with us. 00:21:45.400 --> 00:21:48.319 Now, we subtract the financial expense. And that's 00:21:48.319 --> 00:21:50.220 the interest on the debt. That's the weight of 00:21:50.220 --> 00:21:53.480 the backpack. In this case, it is $190. That 00:21:53.480 --> 00:21:56.640 seems... Pretty manageable, actually. $190 out 00:21:56.640 --> 00:21:59.640 of a profit of $3 ,400. It's a very healthy coverage 00:21:59.640 --> 00:22:01.859 ratio. This company is not drowning in debt. 00:22:02.079 --> 00:22:05.000 If that financial expense number were, say, $3 00:22:05.000 --> 00:22:07.500 ,000, we'd be looking at a company in a serious 00:22:07.500 --> 00:22:10.299 crisis. But here, it's just a scratch. So we 00:22:10.299 --> 00:22:13.559 take $3 ,400, subtract the $190 in interest. 00:22:13.799 --> 00:22:16.700 Yeah. That leaves us with another acronym. Earnings 00:22:16.700 --> 00:22:19.500 before income taxes, EBT. And that number is 00:22:19.500 --> 00:22:23.079 $3 ,210. We've paid the bankers one more stop 00:22:23.079 --> 00:22:26.720 to go. And now, the tax man cometh. The inevitable. 00:22:26.940 --> 00:22:29.359 The line item is simply income taxes. And the 00:22:29.359 --> 00:22:33.000 number is $1 ,027. Oof. Just look at that for 00:22:33.000 --> 00:22:36.019 a second. We paid $190 to the bank for all the 00:22:36.019 --> 00:22:37.900 capital they lent us, but we are paying over 00:22:37.900 --> 00:22:40.259 $1 ,000 to the government. Wow. That's essentially 00:22:40.259 --> 00:22:43.059 a 32 % effective tax rate on our remaining profit. 00:22:43.599 --> 00:22:45.680 And so finally, after that last big withdrawal, 00:22:45.859 --> 00:22:47.980 we arrive at the very bottom line, net income, 00:22:48.220 --> 00:22:52.099 $2 ,183. Now let's just zoom out and look at 00:22:52.099 --> 00:22:54.400 the carnage. I mean, we started with over $20 00:22:54.400 --> 00:22:57.920 ,000 in revenue. The fundamental earnings potential 00:22:57.920 --> 00:23:03.519 of the firm, our hero metric, EBIT, was $3 ,355. 00:23:03.740 --> 00:23:07.130 Right. But the actual cash available to the shareholders 00:23:07.130 --> 00:23:10.369 at the end of the day, the net income, was only 00:23:10.369 --> 00:23:14.089 $2 ,183. It really puts it all in perspective. 00:23:14.230 --> 00:23:17.450 The business itself generated over $3 ,300 of 00:23:17.450 --> 00:23:19.970 value. But the environment it operates in, its 00:23:19.970 --> 00:23:22.670 capital structure, and its tax code reduced that 00:23:22.670 --> 00:23:25.319 all the way down to less than $2 ,200. And that 00:23:25.319 --> 00:23:27.599 is the entire point of this deep dive. If you 00:23:27.599 --> 00:23:31.619 only look at that $2 ,183 number, you are judging 00:23:31.619 --> 00:23:33.859 the business based on the tax code and the debt 00:23:33.859 --> 00:23:37.539 load. If you look at the $3 ,355 number, you're 00:23:37.539 --> 00:23:39.720 judging the business based on its actual fundamental 00:23:39.720 --> 00:23:41.940 performance. We mentioned an acronym in there 00:23:41.940 --> 00:23:44.160 that I want to circle back on, EBT earnings before 00:23:44.160 --> 00:23:46.720 taxes. Let's dive a little deeper into that in 00:23:46.720 --> 00:23:48.759 Section 5. Why do we even need this EBT thing? 00:23:48.799 --> 00:23:50.779 It feels like just a halfway house between EBIT 00:23:50.779 --> 00:23:52.480 and net income. It does feel like just an intermediate 00:23:52.480 --> 00:23:54.859 step, but it has a very specific... and very 00:23:54.859 --> 00:23:58.759 useful purpose. The formula is simple. EBT equals 00:23:58.759 --> 00:24:01.480 EBIT minus interest. But why does it matter? 00:24:01.519 --> 00:24:03.980 Why stop the train there? It matters most for 00:24:03.980 --> 00:24:06.720 international comparisons. Let's go back to our 00:24:06.720 --> 00:24:10.420 two marathon runners. Imagine runner A and runner 00:24:10.420 --> 00:24:13.460 B are identical in every way. They have the same 00:24:13.460 --> 00:24:15.480 athletic ability, so they have the same EBIT. 00:24:15.519 --> 00:24:18.220 They're carrying identical 50 -pound backpacks, 00:24:18.259 --> 00:24:21.730 so they have the same... Interest expense. After 00:24:21.730 --> 00:24:24.109 interest, they have the same EBT. Exactly. But 00:24:24.109 --> 00:24:27.150 now let's say runner A runs their race in Ireland, 00:24:27.250 --> 00:24:30.069 where the corporate tax rate is famously low, 00:24:30.210 --> 00:24:33.910 around 12 .5%. And runner B. Runner B runs their 00:24:33.910 --> 00:24:36.190 race in France, where the corporate tax rate 00:24:36.190 --> 00:24:38.410 is much, much higher. So at the finish line, 00:24:38.630 --> 00:24:41.049 runner A is going to have a massive net income 00:24:41.049 --> 00:24:43.509 compared to runner B. A huge difference, yes. 00:24:43.980 --> 00:24:45.740 If you only look at net income, you'd say, wow, 00:24:45.900 --> 00:24:47.980 the Irish company is a much better company. But 00:24:47.980 --> 00:24:50.920 is it a better company? No, it's the same company. 00:24:50.980 --> 00:24:53.140 It's just in a better tax jurisdiction. Exactly. 00:24:53.380 --> 00:24:56.880 EBT lets you see that clearly. Since EBT is calculated 00:24:56.880 --> 00:24:59.559 after the company's specific decision of interest 00:24:59.559 --> 00:25:02.119 payments, but before the government's specific 00:25:02.119 --> 00:25:05.339 reality of taxes, it isolates the tax environment. 00:25:05.660 --> 00:25:08.039 So if two companies have the exact same EBT. 00:25:08.670 --> 00:25:11.329 but they have different net incomes. The only 00:25:11.329 --> 00:25:13.190 difference between them is the government. Correct. 00:25:13.369 --> 00:25:16.069 It separates fiscal policy from operational performance. 00:25:16.450 --> 00:25:19.450 It's a very powerful tool for comparing companies 00:25:19.450 --> 00:25:21.950 across different countries. Now, we can't have 00:25:21.950 --> 00:25:23.869 a conversation about financial acronyms without 00:25:23.869 --> 00:25:26.829 acknowledging that the finance world just loves 00:25:26.829 --> 00:25:29.109 to make this stuff complicated. They do. The 00:25:29.109 --> 00:25:31.910 source has a see -also list that honestly reads 00:25:31.910 --> 00:25:34.400 like a Scrabble board. I want to do a rapid fire 00:25:34.400 --> 00:25:36.079 round here. I'll give you the letters. You tell 00:25:36.079 --> 00:25:38.440 me why on earth anyone would need this. All right, 00:25:38.440 --> 00:25:41.480 let's do it. First up, EBITDA. That's earnings 00:25:41.480 --> 00:25:44.660 before interest, taxes, and amortization. Notice 00:25:44.660 --> 00:25:47.740 the D for depreciation is missing. OK, so this 00:25:47.740 --> 00:25:50.079 is mainly for the tech world or pharmaceuticals. 00:25:50.599 --> 00:25:53.619 Amortization is what you do for intangible assets, 00:25:53.940 --> 00:25:56.019 things you can't touch like patent software code 00:25:56.019 --> 00:25:59.160 or brand recognition. Depreciation is for physical 00:25:59.160 --> 00:26:01.480 things like trucks and buildings. So if I'm a 00:26:01.480 --> 00:26:03.640 pure software company, I don't really have any 00:26:03.640 --> 00:26:07.519 trucks to depreciate. But I have massive amortization 00:26:07.519 --> 00:26:09.779 charges from writing off the cost of developing 00:26:09.779 --> 00:26:12.460 my software over many years. So EBITDA lets you 00:26:12.460 --> 00:26:15.039 see the cash flow from that software business. 00:26:15.710 --> 00:26:18.289 Without the big non -cash amortization charge. 00:26:18.430 --> 00:26:21.049 Exactly. It strips out the big intangible expense, 00:26:21.150 --> 00:26:24.190 but keeps depreciation in just in case you happen 00:26:24.190 --> 00:26:26.309 to have a few computer servers in a closet somewhere. 00:26:26.609 --> 00:26:29.430 It's niche, but very useful for those IK heavy 00:26:29.430 --> 00:26:33.009 firms. Okay, let's flip it. Ebitin. Earnings 00:26:33.009 --> 00:26:36.269 before interest, taxes, and depreciation. No 00:26:36.269 --> 00:26:38.599 amortization. This is the reverse. You'd use 00:26:38.599 --> 00:26:40.660 this for a heavy manufacturing company, maybe, 00:26:40.740 --> 00:26:43.000 that has zero patents but owns tons of heavy 00:26:43.000 --> 00:26:45.319 machinery. Honestly, you almost never see this 00:26:45.319 --> 00:26:46.940 one in the wild. It's a bit of a theoretical 00:26:46.940 --> 00:26:49.460 unicorn. Good to know. Okay, here's my personal 00:26:49.460 --> 00:26:51.099 favorite, just because it sounds like a weapon 00:26:51.099 --> 00:26:55.160 from a James Bond movie. Ebitdar. Ah, yes! Earnings 00:26:55.160 --> 00:26:57.539 before interest, taxes, depreciation, amortization, 00:26:57.720 --> 00:27:00.579 and... restructuring or rent costs. What is that 00:27:00.579 --> 00:27:03.339 R all about? The R is crucial. It usually stands 00:27:03.339 --> 00:27:06.400 for rent. This is what I call the McDonald's 00:27:06.400 --> 00:27:08.660 versus Burger King metric. OK, explain that. 00:27:08.779 --> 00:27:11.599 I'm intrigued. So McDonald's is famous for its 00:27:11.599 --> 00:27:13.980 real estate strategy. They generally own their 00:27:13.980 --> 00:27:15.960 own locations. They buy the land. They own the 00:27:15.960 --> 00:27:18.680 building. Right. So they don't pay rent. Instead, 00:27:18.980 --> 00:27:21.859 their income statement shows. Depreciation on 00:27:21.859 --> 00:27:24.079 the building and interest on the mortgage they 00:27:24.079 --> 00:27:26.779 used to buy the land. And Burger King. Historically, 00:27:26.819 --> 00:27:29.160 Burger King has often leased its locations from 00:27:29.160 --> 00:27:31.539 landlords. So their income statement shows a 00:27:31.539 --> 00:27:35.680 huge rent expense every single month. And rent 00:27:35.680 --> 00:27:37.880 is an operating expense. It comes out before 00:27:37.880 --> 00:27:40.980 you even calculate EBIT. So if I try to compare 00:27:40.980 --> 00:27:44.589 McDonald's and Burger King. Just using standard 00:27:44.589 --> 00:27:47.329 EBIT. Burger King looks terrible. Its profit 00:27:47.329 --> 00:27:50.369 has been smashed by this huge rent expense. McDonald's 00:27:50.369 --> 00:27:52.589 looks fantastic because its equivalent costs, 00:27:52.730 --> 00:27:55.309 the interest and the depreciation are added back 00:27:55.309 --> 00:27:57.750 or excluded from EBIT. That seems completely 00:27:57.750 --> 00:27:59.509 unfair. They're both in the business of selling 00:27:59.509 --> 00:28:01.650 burgers. It is unfair. And that's why we use 00:28:01.650 --> 00:28:03.430 EBITDA. For Burger King, we take their regular 00:28:03.430 --> 00:28:05.690 EBIT and we add the rent expense back to the 00:28:05.690 --> 00:28:07.490 number. So it's like pretending they didn't pay 00:28:07.490 --> 00:28:09.549 rent. It's like putting them on a level playing 00:28:09.549 --> 00:28:12.589 field. Now we can compare the operational performance 00:28:12.589 --> 00:28:15.750 of the two burger joints without their different 00:28:15.750 --> 00:28:18.210 real estate strategies completely skewing the 00:28:18.210 --> 00:28:20.450 numbers. It levels the playing field between 00:28:20.450 --> 00:28:23.470 the renters and the owners. That is actually 00:28:23.470 --> 00:28:25.880 incredibly useful. You're removing the real estate 00:28:25.880 --> 00:28:28.480 noise to better hear the burger signal. That 00:28:28.480 --> 00:28:30.819 is the goal of all of these different acronyms. 00:28:30.839 --> 00:28:33.500 It's all about trying to isolate the signal from 00:28:33.500 --> 00:28:35.839 the noise. One more heavy hitter from the list, 00:28:36.700 --> 00:28:39.900 EBITDA. This one sounds like a valuation metric. 00:28:40.079 --> 00:28:42.579 This is the valuation king. Enterprise value 00:28:42.579 --> 00:28:45.000 divided by EBITDA. You know, the classic P -E 00:28:45.000 --> 00:28:47.920 ratio, right? Price to earnings. Sure. A stock 00:28:47.920 --> 00:28:50.160 share price divided by its net income per share. 00:28:50.440 --> 00:28:53.359 Right. Well, you can think of EVBITDA as the 00:28:53.359 --> 00:28:55.900 PE ratio for the pros. It's a much more robust 00:28:55.900 --> 00:28:58.519 metric. How so? Instead of using price, which 00:28:58.519 --> 00:29:00.420 is really just the market value of the equity, 00:29:00.619 --> 00:29:05.059 we use enterprise value or EV. EV is the value 00:29:05.059 --> 00:29:07.200 of the whole company equity and debt combined. 00:29:07.519 --> 00:29:09.119 So it's what it would cost to buy the entire 00:29:09.119 --> 00:29:11.900 company outright. The whole shebang. And instead 00:29:11.900 --> 00:29:14.440 of using net income in the denominator, which 00:29:14.440 --> 00:29:16.960 we now know is distorted by tax rates and debt 00:29:16.960 --> 00:29:20.299 levels, we use EBITDA, which is a much rower 00:29:20.299 --> 00:29:22.740 proxy for cash flow. So this is the multiple 00:29:22.740 --> 00:29:24.799 that's used in those leveraged buyouts we talked 00:29:24.799 --> 00:29:26.859 about at the beginning. 100 percent. If you hear 00:29:26.859 --> 00:29:29.000 a private equity banker say we're buying them 00:29:29.000 --> 00:29:31.500 at eight times, they almost always mean eight 00:29:31.500 --> 00:29:34.720 times EBITDA. It is the standard yardstick for 00:29:34.720 --> 00:29:38.039 buying and selling entire companies. We have 00:29:38.039 --> 00:29:40.109 covered a lot of ground. I mean, we've defined 00:29:40.109 --> 00:29:41.789 the terms. We've walked through the math. We've 00:29:41.789 --> 00:29:44.630 explored the entire alphabet soup. But we need 00:29:44.630 --> 00:29:47.009 to end Section 6 with a bit of a reality check. 00:29:47.509 --> 00:29:51.269 Critical takeaways and limitations. Because for 00:29:51.269 --> 00:29:54.910 all of this supposed precision, is EBIT actually 00:29:54.910 --> 00:29:57.410 the truth? That is the danger, isn't it? We start 00:29:57.410 --> 00:29:59.430 to treat these numbers like they're laws of physics, 00:29:59.670 --> 00:30:01.609 like they're gravity. But they're not. They're 00:30:01.609 --> 00:30:04.440 accounting. And accounting has rules. The source 00:30:04.440 --> 00:30:06.680 links this whole discussion to accounting standards 00:30:06.680 --> 00:30:09.279 like GAAP in the U .S. and IFRS internationally. 00:30:09.759 --> 00:30:12.440 These are the rule books. But it also has a section 00:30:12.440 --> 00:30:16.220 with a very ominous title, misconduct. Yes. And 00:30:16.220 --> 00:30:18.920 under that heading, you see phrases like earnings 00:30:18.920 --> 00:30:22.240 management, creative accounting, off -balance 00:30:22.240 --> 00:30:24.799 sheet items. Creative accounting. It sounds like 00:30:24.799 --> 00:30:26.759 an art class you'd take in college, but it's 00:30:26.759 --> 00:30:29.160 actually how you go to jail. Or at least how 00:30:29.160 --> 00:30:32.140 you seriously mislead investors. So how does 00:30:32.140 --> 00:30:34.720 this apply to EBIT? How can it be manipulated? 00:30:35.180 --> 00:30:37.059 Well, think about that fine line we drew earlier 00:30:37.059 --> 00:30:39.559 between operating expenses and non -operating 00:30:39.559 --> 00:30:43.680 expenses. Okay. That line is, well, it's semi 00:30:43.680 --> 00:30:46.400 -permeable. It can be a little fuzzy. Give me 00:30:46.400 --> 00:30:50.059 a scenario. Okay. Let's say I'm the CEO of a 00:30:50.059 --> 00:30:52.960 company, and we've had a terrible year selling 00:30:52.960 --> 00:30:55.839 our main product, our widgets. My operating profit 00:30:55.839 --> 00:30:57.960 is going to look really low. And your bonus is 00:30:57.960 --> 00:31:00.420 tied to operating profit. My bonus is tied to 00:31:00.420 --> 00:31:03.079 operating profit. But I get a great offer on 00:31:03.079 --> 00:31:05.460 an old warehouse the company owns, and I decide 00:31:05.460 --> 00:31:07.539 to sell it for a huge one -time profit. That 00:31:07.539 --> 00:31:09.359 should be classified as non -operating income. 00:31:09.500 --> 00:31:11.359 Right. It should be. It has nothing to do with 00:31:11.359 --> 00:31:14.180 selling widgets. But what if I argue... Well, 00:31:14.500 --> 00:31:16.720 you know, managing our real estate portfolio 00:31:16.720 --> 00:31:20.240 is a key part of our overall operations. So my 00:31:20.240 --> 00:31:22.920 accountants classify that gain as operating income. 00:31:23.180 --> 00:31:25.740 And suddenly your operating profit looks fantastic. 00:31:26.119 --> 00:31:29.680 My margins look great. My bonus gets paid. The 00:31:29.680 --> 00:31:32.579 market is happy. And since EBIT includes both 00:31:32.579 --> 00:31:35.539 operating and non -operating income, the final 00:31:35.539 --> 00:31:39.160 EBIT number is the same either way. But the quality 00:31:39.160 --> 00:31:42.319 of that EBIT is complete garbage. Exactly. It's 00:31:42.319 --> 00:31:44.599 built on a one -time event. not a sustainable 00:31:44.599 --> 00:31:46.900 business. Or think about restructuring charges. 00:31:47.519 --> 00:31:49.960 Companies love to claim certain expenses are 00:31:49.960 --> 00:31:51.839 one -time events. We hear that all the time. 00:31:51.960 --> 00:31:53.740 Oh, we had to fire 10 ,000 people, but that's 00:31:53.740 --> 00:31:55.480 a one -time cost, so please ignore it and look 00:31:55.480 --> 00:31:57.539 at our adjusted EBIT. But if your company is 00:31:57.539 --> 00:31:59.940 restructuring every single year... It's not a 00:31:59.940 --> 00:32:01.920 one -time cost anymore. It's just the cost of 00:32:01.920 --> 00:32:04.140 doing business. It's an operating expense. So 00:32:04.140 --> 00:32:06.559 what you're saying is that while EBIT is great 00:32:06.559 --> 00:32:10.059 at removing the financing and tax noise, it's 00:32:10.059 --> 00:32:12.640 still completely subject to the classification. 00:32:13.069 --> 00:32:15.269 noise that's created by the accountants. Absolutely. 00:32:15.490 --> 00:32:18.390 And that classification can be a subjective art, 00:32:18.490 --> 00:32:22.069 not a hard science. One manager's core operating 00:32:22.069 --> 00:32:25.509 expense is another manager's unusual one -time 00:32:25.509 --> 00:32:28.369 restructuring charge. You have to trust the classification. 00:32:28.809 --> 00:32:31.569 And history has shown us that that trust is sometimes 00:32:31.569 --> 00:32:35.029 misplaced. This has been a true, true deep dive. 00:32:35.130 --> 00:32:36.950 Let's try to bring it all home. Let's wrap this 00:32:36.950 --> 00:32:38.789 up in the outro. Okay, let's recap the journey. 00:32:39.359 --> 00:32:41.680 We start at the top of the waterfall with revenue. 00:32:41.859 --> 00:32:44.480 We fight our way down through the costs of making 00:32:44.480 --> 00:32:46.740 our goods and running the office to find our 00:32:46.740 --> 00:32:50.079 first major landmark operating profit. But we 00:32:50.079 --> 00:32:52.359 don't stop there. We don't stop there. We adjust 00:32:52.359 --> 00:32:54.700 for any of the side hustles, the non -operating 00:32:54.700 --> 00:32:57.359 income and expenses to finally arrive at our 00:32:57.359 --> 00:33:00.069 holy grail number for today. EBIT. And this is 00:33:00.069 --> 00:33:01.769 our horsepower number. This is our horsepower. 00:33:02.029 --> 00:33:03.829 It tells us the fundamental earnings potential 00:33:03.829 --> 00:33:06.069 of the firm, stripped of all the other noise. 00:33:06.269 --> 00:33:08.069 And as the professional investor, we use that 00:33:08.069 --> 00:33:10.849 EBIT number to judge the engine, not the fuel 00:33:10.849 --> 00:33:13.150 that's currently in the tank. Yeah. We now know 00:33:13.150 --> 00:33:15.950 that net income is a result of decisions, decisions 00:33:15.950 --> 00:33:19.329 about debt and tax domicile, while EBIT is a 00:33:19.329 --> 00:33:22.490 result of pure operations. You can't fix a broken 00:33:22.490 --> 00:33:25.339 engine just by putting cheaper gas in it. And 00:33:25.339 --> 00:33:27.940 you can't fix a fundamentally bad business model 00:33:27.940 --> 00:33:31.440 just by refinancing your debt. EBIT tells you 00:33:31.440 --> 00:33:33.160 if the engine is actually good to begin with. 00:33:33.380 --> 00:33:36.339 I love that. Now, we always like to leave you 00:33:36.339 --> 00:33:38.400 with a final provocative thought, something to 00:33:38.400 --> 00:33:40.700 chew on after we're done. What's lingering in 00:33:40.700 --> 00:33:42.859 your brain from this whole discussion? I keep 00:33:42.859 --> 00:33:44.900 coming back to that misconduct section in the 00:33:44.900 --> 00:33:48.440 source material. We place so much faith in these 00:33:48.440 --> 00:33:51.779 acronyms. We do. We build these complex billion 00:33:51.779 --> 00:33:54.079 dollar valuation models based on them. We make 00:33:54.079 --> 00:33:56.640 huge decisions with them. But if you look at 00:33:56.640 --> 00:33:59.460 the source's own list of related accounting topics, 00:33:59.700 --> 00:34:02.119 you see terms like creative accounting and earnings 00:34:02.119 --> 00:34:04.279 management sitting right there next to the clean 00:34:04.279 --> 00:34:06.579 definitions of profit. To neighbors. They are 00:34:06.579 --> 00:34:09.579 neighbors. And it makes you wonder when you open 00:34:09.579 --> 00:34:12.260 a beautifully designed annual report and you 00:34:12.260 --> 00:34:15.860 see that. big, bold EBIT number presented so 00:34:15.860 --> 00:34:19.280 clearly, are you really looking at the objective 00:34:19.280 --> 00:34:21.599 performance of a machine? Or are you looking 00:34:21.599 --> 00:34:24.059 at a number that was massaged and shifted and 00:34:24.059 --> 00:34:27.179 classified to look as pretty as it possibly could? 00:34:27.360 --> 00:34:29.960 That's a good question. We trust EBIT to tell 00:34:29.960 --> 00:34:33.360 us the fundamental potential of a business. But 00:34:33.360 --> 00:34:35.320 how much of what we're seeing is fundamental 00:34:35.320 --> 00:34:38.019 performance and how much of it is fundamental 00:34:38.019 --> 00:34:41.400 creativity? That is a scary thought. Are we buying 00:34:41.400 --> 00:34:43.599 the engine or are we just buying a really, really 00:34:43.599 --> 00:34:46.239 nice paint job? Listeners, thank you for diving 00:34:46.239 --> 00:34:48.539 deep with us today. Next time you're in that 00:34:48.539 --> 00:34:50.440 meeting and you hear the alphabet soup, don't 00:34:50.440 --> 00:34:53.340 be intimidated. Grab your spoon. You know what 00:34:53.340 --> 00:34:55.440 the letters mean now. Keep calculating. We'll 00:34:55.440 --> 00:34:56.500 see you on the next Deep Dive.