What do we understand by EBITDA, which is one of the most commonly used terms in financial parlance? Simply put it is the Earnings before Interest, taxes, depreciation and amortization. Essentially what you do is to take the EBIT (Earnings before interest and taxes) and add back the non-cash charges like depreciation and amortization. In other words, EBITDA represents your profit from the goods sold after adjusted for fixed costs. However, EBITDA does not consider the investment decisions of the company as the depreciation on fixed assets and the interest on loans are excluded from the calculation. You need to distinguish EBITDA from operating profits. EBIT is representation of your operating profits, not EBITDA.
One of the common measures for companies that are very capital intensive is EV/EBITDA. Companies with high gestation do not have profits in the early year and hence P/E cannot be calculated. Hence EV/EBITDA is a better measure. The question then is why do companies trade at different EBITDA multiples? What is a good EBITDA multiple and is there an EBITDA multiple valuation model. Before understanding valuation using EBITDA one needs to understand the concept of EBITDA margins. Interestingly, you will find wide variances in the EBITDA margins across industries. For example companies with high debt or high asset bases will show high EBITDA margins as the cost of debt and the asset depletion are not considered.
Let us look at 6 factors that lead to differences in EBITDA across sectors..
Level of inflation in the price of raw materials is a key factor. For example, certain inputs like crude oil and food inputs may be subject to high levels of inflation. Metals as inputs may be subject to high levels of inflation during the up cycle but will have deflation in the down cycle. Inflation or deflation in the price of inputs makes a huge difference to EBITDA margins. Similarly, companies that make food products tend to benefit from food inflation and see EBITDA expansion due to higher end product prices.
In-built mark-up on the core product is a key determinant of the EBITDA margins. We are talking about the operating mark-ups here. For example, pharma companies and IT companies tend to have healthy mark ups in their pricing model, although that is now coming under pressure. In case of telecom, the operational mark up is still high as most of the cost is capital in nature and that is not considered in your EBITDA margins. The average mark-up on the product price makes a huge impact on the EBITDA margin.
Is interest cost an operating cost or not an operating cost? This is a very subtle point. For example, if you see the EBITDA margins of an SBI, ICICI or HDFC Bank it will be in excess of 70%. That is because the EBITDA margins are calculated net of interest costs. But in case of banks, the interest cost is actually the operating cost. That is because banks actually thrive on the spread between the yield on funds and the cost of funds. Hence to get a clearer picture in the case of banks, NBFCs and other financials, interest cost will have to be considered as an operating cost.
Regulatory issues also make an impact on the EBITDA margins. For example, sectors like power and infrastructure operate on a model where the IRR on their investment is assured at certain hurdle rate. That puts a cap on their EBITDA margins. Secondly. Higher taxes, especially on products like cigarettes and alcohol also tend to impact the EBITDA margins of the company. There are industries like coal and cement which is subjected to stringent compliances and that also puts pressure on their EBITDA margins.
Competitive pressures make a big difference to the EBITDA margins. For example, other factors remaining constant, a sector with higher competitive pressure will face a squeeze on EBITDA margins. For example, FMCG has long seen price wars. Currently, we are seeing price wars in telecom and data services. This pulls down pricing power substantially and leads to thinner EBITDA margins.
Sectors that are vulnerable to shifts in consumer preferences of competition in the form of alternate products are likely to be subjected to thin margins. For example, landline service providers faced severe pressure from mobile services. PSU banks and insurers have already seen pressure from private players in the industry. Globally, we saw how the shift towards smart phones almost led to the demise of Nokia. Such sectors where there is potential for disruption; they tend to see sharp shifts in EBITDA margins. You need to build that into your valuation models.