Welcome back to the Deep Dive. I want you to
just picture a scene for a moment. Okay. You've
just walked into a high -stakes meeting. Could
be a boardroom, could be, you know, one of those
Zoom calls with investors who have those very
expensive -looking bookshelves. No, I know the
ones. The curated ones. Exactly. Yeah. And you're
feeling good. You've done your reading. But then
the conversation starts, and it's like English
just leaves the room. There's a definite shift,
isn't there? It is a palpable shift. Yeah. People
stop using normal words like, profit or, you
know, spending, they start talking in code. It's
the alphabet soup. It is the alphabet soup. Someone
asks about the ROI. Someone else pivots to the
CAGR. And then the person at the head of the
table with a very serious face asks, but what's
the EBITDA looking like compared to the ROE?
Right. And if you don't know the secret handshake,
if you don't know the code, you just sort of
sit there nodding. Hoping nobody asks you a direct
question. Exactly. Hoping they don't call on
you. It can feel incredibly exclusionary. I mean,
it's designed to be precise. I get that. But
a lot of the time it just functions as a kind
of date keeping. It does. It separates the money
people from the, you know, the operational people.
It feels like they're guarding a temple. But
today we are going to kick down the door of that
temple. We're going to grab a spoon and we're
going to eat that alphabet soup. I'm in. And
we are focusing on, I think, arguably the most
important acronym in that entire bowl. If you
really want to understand the true horsepower
of a business, not the accounting tricks, not
the tax strategies, but the actual machine itself,
you need to understand one thing. EBIT. E -B
-I -T. Earnings before interest and taxes. It's
a classic for a reason. And I love that you use
the word horsepower. That is exactly the right
way to think about it. So let's lay out the mission
for this deep dive. We're not just going to,
you know, read a definition from a textbook and
move on. No, we're going to tear this thing apart.
We are. We've pulled together a serious stack
of sources for this. We have financial definitions
from Nasdaq, some really good deep dive explainers
from Investopedia, and we're leaning very heavily
on what is, I mean, it's basically the Bible
of investment theory, Essentials of Investments
by Boddy, Kane, and Marcus. That text is absolutely
essential. It frames EBIT not just as a line
on a spreadsheet, but as a real tool for making
decisions. And to make this real, we're not just
going to talk theory. We have a specific statement
of income from the source material. We're going
to go through it line by line. We are going to
track every single dollar from the moment it
enters the company as revenue. all the way down
until it lands, or what's left of it lands, in
a shareholder's pocket. And that walkthrough
is going to be so critical because that's where
the story is. That's where the money hides. You
can talk theory all day, but until you see exactly
where the expenses get deducted, it's all just
abstract. Right. And by the end of this, I want
you, our listener, to go from maybe vaguely recognizing
the term EBIT to thinking like a, well, a ruthless
professional investor. I like it. We want you
to be able to look at a company. and just mentally
strip away all the baggage to see what the core
of it is actually worth. So let's start with
that big picture, the why should I care question.
Why are we so obsessed with earnings before we
pay the bills? It's a really valid question.
I mean, in your personal life, you don't really
care about your earnings before mortgage and
taxes. Not at all. You care about what hits your
checking account, right? What you can actually
spend. Yeah. If I go to my bank and say, hey,
listen, my personal EBIT is huge. I just happen
to have a lot of credit card debt. They're still
going to foreclose on my house. Exactly. In personal
finance, cash is king. End of story. But in corporate
finance, especially when you're analyzing the
quality of a business, looking at the bottom
line, the net income can actually be a trap.
A trap. How so? Isn't that the final score? It's
the final score for the tax man, yes. And it's
the final score for the current shareholders.
Right. But it doesn't tell you how well the team
is actually playing the game. Okay. I like that
analogy. Let me try one. Imagine you're a scout
and you're looking for a marathon runner. Got
it. You've got two runners. Runner A runs a mile
in six minutes. Runner B runs a mile in eight
minutes. On paper, it's an easy choice. Signed
Runner A. No -brainer. But then you look a little
closer, and you see that Runner B is carrying
a 50 -pound backpack full of rocks. Oh. And not
only that, Runner B is running uphill. in a thunderstorm
and runner a runner a is on a flat dry track
with a nice tailwind okay the context changes
everything everything that backpack is debt the
interest payments are the weight that's dragging
that runner down and that thunderstorm that's
a high tax jurisdiction maybe a runner b operates
in a country with a 40 corporate tax rate while
runner a is set up in a tax haven if you just
look at the finish time the net income you'd
say runner b is slow and you'd walk away but
you be wrong. You'd be totally wrong. Because
if you strip away the backpack, the interest,
and you strip away the bad weather, the taxes,
you might find that runner B is actually a four
minute miler just waiting to be unleashed. And
that is what EBIT does. It takes the backpack
off. Precisely. It allows you to evaluate what
the source calls the fundamental earnings potential
of the firm. It's separate from how it's financed
and separate from where it pays its taxes. It's
the raw athletic ability of the company. I want
to stick with this professional investor persona
for a second because our source material explicitly
mentions this character. Right. It's an investor
who's contemplating a change to the capital structure.
Now that sounds fancy. What does it actually
mean in plain English? Capital structure is just
a fancy way of asking whose money are we using
to run this business? Okay. Are we using our
own money, which is equity, or are we using other
people's money, which is debt? So borrowing from
a bank versus selling shares in the company.
That's it. Now put on your private equity shark
hat for a second. Okay. Shark hat on. You're
hunting for a company to buy. You find a business
that looks a lot like our runner B. It has a
terrible net income. It's barely making a profit
on paper. Most investors would just walk right
by. But not me. Not with my shark hat on. Not
you. Because you, the professional, you look
past the bottom line and you look at the EBIT.
You see that the business itself, the core operation,
is actually making millions. So where's the money
going? It's all being spent paying the interest
on some terrible loan that a previous manager
took out 10 years ago. It's that 50 pound backpack.
So you see an opportunity there. You see a massive
opportunity. You say, I can fix this. So you
go in, you buy the company, you pay off that
bad debt. Maybe you refinance it at a much lower
rate. You get rid of the backpack. You get rid
of the backpack. And suddenly those millions
of dollars that were going straight to the bank
are now flowing into your pocket as profit. And
you haven't changed the product. You haven't
fired a single salesperson. All you did was change
the capital structure. But you never would have
seen that opportunity if you only looked at net
income. Never. Which is why the source emphasizes
that two -step evaluation process. Step one,
evaluate the fundamental earnings potential.
That's EBIT. Step two is then, and only then,
you determine the optimal use of debt versus
equity. You have to keep them separate. You have
to. You can't judge the quality of an engine
if you're distracted by the current price of
gas. Step one is checking the engine. That's
EVIT. Step two is deciding how much gas to put
in the tank. That's the debt decision. If you
mix those two up, you make very bad investments.
Okay, I think we have sold the why. It is a god
mode of investing. It lets you see through the
matrix. Now let's get into the what. Section
one of our outline is defining this core concept.
Based on the sources, let's get the absolute
plain English definition. What is EBIT? At its
most basic, most fundamental level, EBIT is a
measure of a firm's profit that includes all
incomes and all expenses. All of them? Almost.
It takes that big pile of revenue from the top
and it subtracts nearly everything. But... and
this is what we can call the great exclusion,
it stops right before it pays two very specific
entities. The great exclusion. I like that. Who
gets left out of the party? It excludes interest
expenses, so the bankers and bondholders, and
it excludes income tax expenses, so the government.
Hence the name, earnings before interest and
taxes. It's right there on the tin. It sounds
so simple, but I know there are traps here. One
thing I found really interesting in the source
material was the clarification about non -operating
items. I think a lot of people, myself included
sometimes, assume EBIT just means profit from
selling widgets. That is probably the most common
misconception. People immediately confuse EBIT
with operating profit. They think, oh, it's just
the money that's made from the day -to -day core
business. But the source is very specific about
this nuance. EBIT includes all income. So give
me an example. What's an income source that isn't
from the core business? Okay, let's say you run
a bakery. Your core business is selling croissants
and coffee. The money you make from that, that's
your operating income. Makes sense. But let's
say the bakery also happens to own the building
it's in, and you rent out the apartment that's
on the second floor. Okay. That rent money you
collect every month is income, for sure. But
it has absolutely nothing to do with bacon croissants.
That is non -operating income. Or what if the
bakery had a big pile of cash from a good year
and it's just sitting in a savings account earning
2 % interest? Exactly. That interest income you're
earning is non -operating. Now here's the absolute
key. EBIT. includes that rent money from the
apartment. It includes that interest income from
the bank account. It's meant to capture the total
earnings of the entire entity before you pay
your own interest on debt and your taxes to the
government. So if I'm a baker and I sell a million
dollars worth of croissants, but I also happen
to make a million dollars day trading GameStop.
with the company's bank account. Then your EBIT
is $2 million. Wow. And that is why you have
to be so careful. Because if you're an investor
just glancing at that bakery, you might think,
wow, those must be some incredibly profitable
croissants. But in reality, half your profit
is coming from, you know, gambling on mean stocks.
This brings us perfectly to the synonym confusion
part of our outline. I see people use the terms
EBIT and operating income interchangeably all
the time. Even on financial news sites. Are they
just wrong? They're imprecise. Let's call it
that. The source material gives us a very strict,
almost mathematical condition here. It says that
EBIT and operating income are sometimes used
as synonyms. Sometimes. But they are only, and
I mean only, synonyms if the firm has zero non
-operating income and zero non -operating expenses.
Which seems pretty rare for... Any company of
a certain size. In the real world, it's incredibly
rare for a large company. I mean, almost every
major corporation has some side investments or
maybe a one time gain from selling an old factory
or a lawsuit settlement or some currency exchange
gains. Anything. Anything. The moment a company
has even one single dollar of non -operating
income or expense, EBIT and operating income
are no longer the same number. They drift apart.
So going back to our bakery, if I have zero side
hustles, if I just bake and sell, my operating
income is my EBIT. Correct. But the very moment
I rent out that upstairs apartment for the first
time. Their EBIT becomes higher than your operating
income. And why does this distinction matter
so much? It matters because of valuation, what
we talked about before. If you're an investor
and you apply a multiple to the company's earnings
to guess what the whole company is worth, you
need to know if those earnings are sustainable.
Is that EBIT coming from selling croissants year
after year, which is sustainable? Or is it coming
from a one -time sale of the company's delivery
van? A one -off event. Exactly. Both of those
things show up in EBIT. But only the profit from
the croissants shows up in operating income.
It's like saying cash on hand is the same as
salary. I guess for a kid with a paper route,
maybe it is. But for an adult who might have
just sold a car or gotten an inheritance, cash
on hand is a very, very different number from
their weekly salary. That is a perfect analogy.
Complexity breaks the synonym. The bigger and
more complex the company, the less likely it
is that those two numbers are going to be the
same. Okay, let's move on. Section three, the
formulas. We know what it is. We know why we
want it. Now, how do we actually calculate it?
The source offers a few different paths to get
to the truth. Let's start with method A, the
top -down approach. The top -down approach is
the most intuitive way, I think. You're just
following the flow of the money as it comes into
the business. You start at the top of the waterfall.
Exactly. You start at the very top of the income
statement with revenue, the big number, the sales.
And then you just start chipping away. You start
chipping away. First, you subtract the cost of
goods sold. So for our bakery, that's the flour,
the sugar, the direct labor of the bakers. Okay.
Then you subtract all the operating expenses,
the rent for the shop, the marketing budget,
the CEO salary, all of that stuff. And if I just
stop right there, after subtracting all of that.
If you stop there, you've calculated operating
income. Not EBIT. Not EBIT. To get all the way
to EBIT, you have to remember to then adjust
for any of that non -operating stuff we just
talked about. Add any non -operating income.
Subtract any non -operating expenses. But fundamentally,
the top -down method is revenue minus all your
expenses except for interest and taxes. It feels
like the honest way to do it. You really see
where all the money went. But I have to admit,
I'm a big fan of method B, the bottom -up approach.
It feels a bit more like detective work. It's
often the faster way to do it, especially if
you're just skimming a financial report and you
don't want to go through line by line. You just
jump straight to the end of the story. You go
straight to the bottom line. You look at net
income. This is the number after the massacre,
right? After the bank has taken its cut, after
the IRS has taken its huge cut. This is the number
for the survivors. The survivors. And then you
basically resurrect the dead. You take that net
income number and you add the taxes back in.
Then you add the interest payments back in. The
formula being? Ebit equals net income plus interest
plus taxes. Exactly. It's reverse engineering.
It's saying, OK, I see what you have left at
the end of the day. Now let me see what you would
have had if you didn't have these two very specific
obligations. Is one method better than the other?
Do they always give the same answer? Mathematically,
they have to equal the exact same number. If
they don't, then someone is cooking the books.
But practically speaking, the top -down method
is much better for understanding the business
model. You get to see the profit margins at every
single step of the process. The bottom -up method
is better for understanding the capital structure's
impact because you are physically seeing how
much cash was taken out by those interest payments.
There is a third method mentioned in the source
material, the EBITDA bridge. We haven't fully
introduced EBITDA yet, but it's EBIT's louder,
more famous cousin. Right. EBITDA is... Earnings
before interest, taxes, depreciation, and amortization.
It's an even rougher or purer number, depending
on your point of view. It's much closer to a
raw cash flow metric. So if I have the EBITDA
number, how do I use that to get to EBIT? It's
simple. You just subtract the D and the A. You
take EBITDA and you subtract depreciation and
you subtract amortization. But why would I want
to do that? Why not just stick with EBITDA? I
hear that term all the time. Because machines
break. Ovens rust. Computers become obsolete.
Depreciation isn't just some accounting trick.
It represents the very real wear and tear on
your company's physical assets. It's a real cost,
even if you don't write a check for it this year.
It's a very real cost. If you run a trucking
company, your trucks are physically wearing out
every day. If you ignore depreciation and just
use EBITDA, you're basically pretending your
trucks will last forever. They won't. Which they
won't. If you use EBIT, you're acknowledging
the reality that eventually you're going to have
to spend real cash to buy new trucks. So EBIT
is cleaner than net income because it ignores
the financing and tax decisions. Right. But it's
dirtier or maybe more realistic than EBITDA because
it acknowledges the physical reality of your
assets degrading over time. Exactly. You can
think of EBIT as sitting in this perfect Goldilocks
zone. It ignores the money stuff, the interest
in taxes, but it respects the physical stuff,
the depreciation. Okay. Now we are going to do
something we don't often do. We're going to do
some math on a podcast. I'm ready. But don't
panic. We are going to walk through the deep
dive calculation from Section 4 of our outline.
We have a specific statement of income pulled
from our source. I want you to visualize this.
Imagine a spreadsheet, or even better, imagine
a big stack of cash sitting on a table. Let's
do it. The source gives us figures in thousands,
but let's just use the numbers as they are for
simplicity. Yeah. At the very, very top of the
pile, we have sales revenue. The starting rate.
And the number is $20 ,438. Set in there. That
is our total potential. That is every dollar
that customers handed over for our product or
service. Now, the very first hand reaches into
that pile. This is the cost of goods sold or
KGS. This is the raw cost of actually making
the stuff we sold. In our example, this takes
away $7 ,943. Wow. Okay. So that's almost 40
% of our revenue gone instantly. This covers
the direct labor, the raw materials, the cost
to run the factory. If this number is too high
relative to revenue, nothing else down the line
even matters. So we take our $20 ,438. We subtract
that $7 ,943. We're left with a subtotal called
growth profit. And that number is $12 ,495. Okay,
so we still have more than half of our money
left. The business looks fundamentally healthy
so far. But now comes the messy middle. The operating
expenses. This is where the overhead and the
bloat can hide. Let's list the items that are
eating away at our pile of cash. First up, the
big one. Selling, general, and administrative
expenses. SG &A. This is usually the biggest
bucket of miscellaneous costs. It's your marketing
department, your sales commissions, HR team,
the legal department, the rent on your corporate
headquarters. The whole works. The whole works.
And in our example, this eats up $8 ,172. Well,
wait a second. Hold on. We had just under $12
,500 in gross profit, and we just spent over
$8 ,000 on admin. That feels like a lot. It is
a lot. And as an investor, that is the very first
line I would circle with a red pen. Why does
it cost us over eight grand to support selling
20 grand worth of goods? Is the CEO flying on
private jets? Are we spending way too much on
Super Bowl ads? This line item is where efficiency
lives or dies. OK, so our pile is shrinking really
fast. What's next? Next up is depreciation and
amortization. This line item is $960. Now, this
is an interesting one. Did we actually write
a check to someone for $960 this year? No. And
that's the key distinction. This is a non -cash
expense. We didn't actually pay anyone. The cash
is still technically in the building. We just,
on paper, admitted that our factory equipment
and other assets lost $960 worth of value this
year. So it reduces our profit for tax purposes,
but it doesn't reduce our cash in hand. For this
period, that's right. And finally, there's a
small line item for other expenses at $138. So
if we add all those up, our total operating expenses
are $9 ,270. A big number. very big number. So
we subtract that from our gross profit. What
are we left with? We are now left with operating
profit. The math is $12 ,495 minus $9 ,207. That
gives us a grand total of $3 ,225. Okay, stop
the tape right there. $3 ,225. Is this our EBIT?
Have we arrived? Not quite yet. And this is the
exact moment where that synonym confusion we
talked about earlier gets resolved in the real
world. Why isn't this EBIT? We've subtracted
all the operating costs. It's called operating
profit. Because if you look closely at the income
statement from our source, there is one more
specific line item just below the operating line.
It says non -operating income of $130. Ah, there
it is. The side hustle. The apartment rental.
Exactly. Maybe this company sold off an old patent,
or they had some cash sitting in a high -yield
savings account that paid them some interest.
That $130 is real profit, but it's not operating
profit, however. It is part of earnings before
interest and taxes. It absolutely is. So we have
to add it back in. We take our operating profit
of $3 ,225, and we add that $130 of non -operating
income. And now, the reveal. EBIT is $3 ,355.
I'm going to pause on this for a second. This
is so important. The operating profit was $3
,225. The EBIT is 3355. They're different numbers.
They are. And look, in this specific example,
the difference is pretty small, only $130. But
imagine if that non -operating income line was
$3 ,000 because the company sold a massive piece
of land it wasn't using. Then EBIT would be almost
double the operating profit. Exactly. And if
you, as an investor, just looked at that big
EBIT number, you might think the core business
was absolutely booming. But the core business,
the operating profit, hasn't changed at all.
This is why you always have to read the footnotes
in a financial report. You have to. OK, so we
have our core number. EBIT is $3 ,355. This is
the horsepower. This is what the machine itself
actually generated this year. But we're not done.
The stack of cash is about to get raided by those
two entities we excluded earlier. Right. We were
at earnings before interest and taxes. So now
it's time to handle the interest and the taxes.
The income statement in the source first lists
financial income of $45. We add that in. That
brings us to a little subtotal called income
before interest expense, IBE, of $3 ,400. This
is getting granular, I know, but bear with us.
Now, we subtract the financial expense. And that's
the interest on the debt. That's the weight of
the backpack. In this case, it is $190. That
seems... Pretty manageable, actually. $190 out
of a profit of $3 ,400. It's a very healthy coverage
ratio. This company is not drowning in debt.
If that financial expense number were, say, $3
,000, we'd be looking at a company in a serious
crisis. But here, it's just a scratch. So we
take $3 ,400, subtract the $190 in interest.
Yeah. That leaves us with another acronym. Earnings
before income taxes, EBT. And that number is
$3 ,210. We've paid the bankers one more stop
to go. And now, the tax man cometh. The inevitable.
The line item is simply income taxes. And the
number is $1 ,027. Oof. Just look at that for
a second. We paid $190 to the bank for all the
capital they lent us, but we are paying over
$1 ,000 to the government. Wow. That's essentially
a 32 % effective tax rate on our remaining profit.
And so finally, after that last big withdrawal,
we arrive at the very bottom line, net income,
$2 ,183. Now let's just zoom out and look at
the carnage. I mean, we started with over $20
,000 in revenue. The fundamental earnings potential
of the firm, our hero metric, EBIT, was $3 ,355.
Right. But the actual cash available to the shareholders
at the end of the day, the net income, was only
$2 ,183. It really puts it all in perspective.
The business itself generated over $3 ,300 of
value. But the environment it operates in, its
capital structure, and its tax code reduced that
all the way down to less than $2 ,200. And that
is the entire point of this deep dive. If you
only look at that $2 ,183 number, you are judging
the business based on the tax code and the debt
load. If you look at the $3 ,355 number, you're
judging the business based on its actual fundamental
performance. We mentioned an acronym in there
that I want to circle back on, EBT earnings before
taxes. Let's dive a little deeper into that in
Section 5. Why do we even need this EBT thing?
It feels like just a halfway house between EBIT
and net income. It does feel like just an intermediate
step, but it has a very specific... and very
useful purpose. The formula is simple. EBT equals
EBIT minus interest. But why does it matter?
Why stop the train there? It matters most for
international comparisons. Let's go back to our
two marathon runners. Imagine runner A and runner
B are identical in every way. They have the same
athletic ability, so they have the same EBIT.
They're carrying identical 50 -pound backpacks,
so they have the same... Interest expense. After
interest, they have the same EBT. Exactly. But
now let's say runner A runs their race in Ireland,
where the corporate tax rate is famously low,
around 12 .5%. And runner B. Runner B runs their
race in France, where the corporate tax rate
is much, much higher. So at the finish line,
runner A is going to have a massive net income
compared to runner B. A huge difference, yes.
If you only look at net income, you'd say, wow,
the Irish company is a much better company. But
is it a better company? No, it's the same company.
It's just in a better tax jurisdiction. Exactly.
EBT lets you see that clearly. Since EBT is calculated
after the company's specific decision of interest
payments, but before the government's specific
reality of taxes, it isolates the tax environment.
So if two companies have the exact same EBT.
but they have different net incomes. The only
difference between them is the government. Correct.
It separates fiscal policy from operational performance.
It's a very powerful tool for comparing companies
across different countries. Now, we can't have
a conversation about financial acronyms without
acknowledging that the finance world just loves
to make this stuff complicated. They do. The
source has a see -also list that honestly reads
like a Scrabble board. I want to do a rapid fire
round here. I'll give you the letters. You tell
me why on earth anyone would need this. All right,
let's do it. First up, EBITDA. That's earnings
before interest, taxes, and amortization. Notice
the D for depreciation is missing. OK, so this
is mainly for the tech world or pharmaceuticals.
Amortization is what you do for intangible assets,
things you can't touch like patent software code
or brand recognition. Depreciation is for physical
things like trucks and buildings. So if I'm a
pure software company, I don't really have any
trucks to depreciate. But I have massive amortization
charges from writing off the cost of developing
my software over many years. So EBITDA lets you
see the cash flow from that software business.
Without the big non -cash amortization charge.
Exactly. It strips out the big intangible expense,
but keeps depreciation in just in case you happen
to have a few computer servers in a closet somewhere.
It's niche, but very useful for those IK heavy
firms. Okay, let's flip it. Ebitin. Earnings
before interest, taxes, and depreciation. No
amortization. This is the reverse. You'd use
this for a heavy manufacturing company, maybe,
that has zero patents but owns tons of heavy
machinery. Honestly, you almost never see this
one in the wild. It's a bit of a theoretical
unicorn. Good to know. Okay, here's my personal
favorite, just because it sounds like a weapon
from a James Bond movie. Ebitdar. Ah, yes! Earnings
before interest, taxes, depreciation, amortization,
and... restructuring or rent costs. What is that
R all about? The R is crucial. It usually stands
for rent. This is what I call the McDonald's
versus Burger King metric. OK, explain that.
I'm intrigued. So McDonald's is famous for its
real estate strategy. They generally own their
own locations. They buy the land. They own the
building. Right. So they don't pay rent. Instead,
their income statement shows. Depreciation on
the building and interest on the mortgage they
used to buy the land. And Burger King. Historically,
Burger King has often leased its locations from
landlords. So their income statement shows a
huge rent expense every single month. And rent
is an operating expense. It comes out before
you even calculate EBIT. So if I try to compare
McDonald's and Burger King. Just using standard
EBIT. Burger King looks terrible. Its profit
has been smashed by this huge rent expense. McDonald's
looks fantastic because its equivalent costs,
the interest and the depreciation are added back
or excluded from EBIT. That seems completely
unfair. They're both in the business of selling
burgers. It is unfair. And that's why we use
EBITDA. For Burger King, we take their regular
EBIT and we add the rent expense back to the
number. So it's like pretending they didn't pay
rent. It's like putting them on a level playing
field. Now we can compare the operational performance
of the two burger joints without their different
real estate strategies completely skewing the
numbers. It levels the playing field between
the renters and the owners. That is actually
incredibly useful. You're removing the real estate
noise to better hear the burger signal. That
is the goal of all of these different acronyms.
It's all about trying to isolate the signal from
the noise. One more heavy hitter from the list,
EBITDA. This one sounds like a valuation metric.
This is the valuation king. Enterprise value
divided by EBITDA. You know, the classic P -E
ratio, right? Price to earnings. Sure. A stock
share price divided by its net income per share.
Right. Well, you can think of EVBITDA as the
PE ratio for the pros. It's a much more robust
metric. How so? Instead of using price, which
is really just the market value of the equity,
we use enterprise value or EV. EV is the value
of the whole company equity and debt combined.
So it's what it would cost to buy the entire
company outright. The whole shebang. And instead
of using net income in the denominator, which
we now know is distorted by tax rates and debt
levels, we use EBITDA, which is a much rower
proxy for cash flow. So this is the multiple
that's used in those leveraged buyouts we talked
about at the beginning. 100 percent. If you hear
a private equity banker say we're buying them
at eight times, they almost always mean eight
times EBITDA. It is the standard yardstick for
buying and selling entire companies. We have
covered a lot of ground. I mean, we've defined
the terms. We've walked through the math. We've
explored the entire alphabet soup. But we need
to end Section 6 with a bit of a reality check.
Critical takeaways and limitations. Because for
all of this supposed precision, is EBIT actually
the truth? That is the danger, isn't it? We start
to treat these numbers like they're laws of physics,
like they're gravity. But they're not. They're
accounting. And accounting has rules. The source
links this whole discussion to accounting standards
like GAAP in the U .S. and IFRS internationally.
These are the rule books. But it also has a section
with a very ominous title, misconduct. Yes. And
under that heading, you see phrases like earnings
management, creative accounting, off -balance
sheet items. Creative accounting. It sounds like
an art class you'd take in college, but it's
actually how you go to jail. Or at least how
you seriously mislead investors. So how does
this apply to EBIT? How can it be manipulated?
Well, think about that fine line we drew earlier
between operating expenses and non -operating
expenses. Okay. That line is, well, it's semi
-permeable. It can be a little fuzzy. Give me
a scenario. Okay. Let's say I'm the CEO of a
company, and we've had a terrible year selling
our main product, our widgets. My operating profit
is going to look really low. And your bonus is
tied to operating profit. My bonus is tied to
operating profit. But I get a great offer on
an old warehouse the company owns, and I decide
to sell it for a huge one -time profit. That
should be classified as non -operating income.
Right. It should be. It has nothing to do with
selling widgets. But what if I argue... Well,
you know, managing our real estate portfolio
is a key part of our overall operations. So my
accountants classify that gain as operating income.
And suddenly your operating profit looks fantastic.
My margins look great. My bonus gets paid. The
market is happy. And since EBIT includes both
operating and non -operating income, the final
EBIT number is the same either way. But the quality
of that EBIT is complete garbage. Exactly. It's
built on a one -time event. not a sustainable
business. Or think about restructuring charges.
Companies love to claim certain expenses are
one -time events. We hear that all the time.
Oh, we had to fire 10 ,000 people, but that's
a one -time cost, so please ignore it and look
at our adjusted EBIT. But if your company is
restructuring every single year... It's not a
one -time cost anymore. It's just the cost of
doing business. It's an operating expense. So
what you're saying is that while EBIT is great
at removing the financing and tax noise, it's
still completely subject to the classification.
noise that's created by the accountants. Absolutely.
And that classification can be a subjective art,
not a hard science. One manager's core operating
expense is another manager's unusual one -time
restructuring charge. You have to trust the classification.
And history has shown us that that trust is sometimes
misplaced. This has been a true, true deep dive.
Let's try to bring it all home. Let's wrap this
up in the outro. Okay, let's recap the journey.
We start at the top of the waterfall with revenue.
We fight our way down through the costs of making
our goods and running the office to find our
first major landmark operating profit. But we
don't stop there. We don't stop there. We adjust
for any of the side hustles, the non -operating
income and expenses to finally arrive at our
holy grail number for today. EBIT. And this is
our horsepower number. This is our horsepower.
It tells us the fundamental earnings potential
of the firm, stripped of all the other noise.
And as the professional investor, we use that
EBIT number to judge the engine, not the fuel
that's currently in the tank. Yeah. We now know
that net income is a result of decisions, decisions
about debt and tax domicile, while EBIT is a
result of pure operations. You can't fix a broken
engine just by putting cheaper gas in it. And
you can't fix a fundamentally bad business model
just by refinancing your debt. EBIT tells you
if the engine is actually good to begin with.
I love that. Now, we always like to leave you
with a final provocative thought, something to
chew on after we're done. What's lingering in
your brain from this whole discussion? I keep
coming back to that misconduct section in the
source material. We place so much faith in these
acronyms. We do. We build these complex billion
dollar valuation models based on them. We make
huge decisions with them. But if you look at
the source's own list of related accounting topics,
you see terms like creative accounting and earnings
management sitting right there next to the clean
definitions of profit. To neighbors. They are
neighbors. And it makes you wonder when you open
a beautifully designed annual report and you
see that. big, bold EBIT number presented so
clearly, are you really looking at the objective
performance of a machine? Or are you looking
at a number that was massaged and shifted and
classified to look as pretty as it possibly could?
That's a good question. We trust EBIT to tell
us the fundamental potential of a business. But
how much of what we're seeing is fundamental
performance and how much of it is fundamental
creativity? That is a scary thought. Are we buying
the engine or are we just buying a really, really
nice paint job? Listeners, thank you for diving
deep with us today. Next time you're in that
meeting and you hear the alphabet soup, don't
be intimidated. Grab your spoon. You know what
the letters mean now. Keep calculating. We'll
see you on the next Deep Dive.