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<p>It's becoming a trend for analysts to compare possible investment opportunities using EBITDA instead of EBIT, particularly in the Telecom sector, this has one main disadvantage, what do you think it is?</p>
EBITDA doesn't include the amortization and the depreciation which in case of the telecom sector a problem as most of the telecom sector has a huge PPE which is misleading and risky.
however, from my POV even EBIT has risks, as it is excluding the effect of the borrowing which at some point if the balance sheet is overlooked.
The answer for this is that EBITDA ignores both operational and financial leverage.
For the telecom sector, PP&E are usually high, and they generate a large amount of fixed costs, by using EBITDA analysts remove the impact of this fixed cost and are thus hiding the disadvantage of high leverage companies and highlighting them as investment opportunities.
The Disadvantages of EBITDA
While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.
Overstates Income: To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and income tax expense.
Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).
Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.
