the three bills it strips out

A friend forwarded an investor deck on Saturday, genuinely excited. EBITDA margin 28 percent. Trading at eight times EBITDA. Looks cheap, he said.

I asked him to scroll one slide down.

Past the EBITDA chart sits the actual profit and loss, and it tells a different story. EBITDA was 280 crore. Then came the lines the highlight slide leaves out. Depreciation of 150, which is the plants and machines wearing out and needing to be replaced. Interest of 90, the cost of the debt that bought those machines. Tax of 10. What reached the owner was 30 crore. A 28 percent margin on the slide became a 3 percent margin at the bottom.

EBITDA stands for earnings before interest, tax, depreciation and amortisation. Read that again. It is the profit before four of the largest bills a business actually pays. For an asset light software firm, those bills are small and EBITDA sits close to reality. For a capital heavy business, telecom, steel, cement, hotels, the depreciation and the interest are the business, and EBITDA is a number that quietly pretends the machines were free and the debt does not exist.

Here is the part that catches people. That cheap looking eight times EBITDA works out to about 41 times earnings once you count what EBITDA skipped. Same 280 of EBITDA, an asset light company keeps 68 rupees of every 100 as profit. The heavy one keeps 11. The gap between EBITDA and net profit is not noise. It is the cost of the assets and the debt, and for a heavy business it is the whole story.

So before you call a margin fat or a multiple cheap, read down to net profit, then check the cash. EBITDA is the profit a business would earn if the machines ran for free and the loan never came due. Neither is true.

How to read the statement before the slide reads it to you: