EBITDA refers to the earnings before interest, taxes, depreciation and amortization. It is arrived at by subtracting the cost of sales and operating expenses from the sales revenue of the company. The EBITDA is normally used as an approximation to operating cash flow but both measures have differences in calculation.
As some companies have high depreciation figures, the net income may not be reflective of the earnings power of the company. These companies usually have large investments in fixed assets. Hence, it is important to look at the EBITDA, which is an indicator of the cash flow health of the company.
EBITDA and Debt
EBITDA can also tell an investor or a trader if a company can pay off its debt. For this reason alone, it is very important to study the financials of the company in detail. If a trader or an investor can do that, he would have an advantage. Some of the most intelligent short sellers in the market conduct in depth research on a company’s ability to pay off its interest payments. If the debt of the company is so high such that its EBITDA cannot exceed interest payments, it is highly likely that the company is in trouble. For option traders, this may be a candidate for a long put strategy.
Implications of EBITDA
An increased EBITDA over time means that the company’s operating cash flow is improving. This could lead to a re-rating of a company’s stock price. In such a scenario, an option trader may initiate moderately bullish to very bullish strategies on the underlying security.
Also, a low enterprise value to EBITDA is often used by private equity firms as a justification to buy out a company’s undervalued share prices. An adept investor or trader is open to a the buyout as a catalyst from forms with low enterprise value to ebitda multiples.
Read: Cash Flow