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What is EBITDA & EPS?

If you even have a basic exposure to the financial markets, you must have at some point come across the term "EBITDA" and "EPS".

Well, these are some very simple terms used to assess the profitability of a company.

Let us understand these terms one at a time.

Starting with the EBITDA of a company...

Understanding EBITDA

EBITDA stands for earnings before interest, tax, depreciation, and amortisation.

So it simply is a company's earnings before all the non-operating expenses like interest, tax, depreciation, and amortisation.

It is one of the most widely used metrics in finance, particularly in valuation analysis.

By stripping away non-operational expenses, EBITDA in theory allows for a cleaner analysis of the intrinsic profitability of a company.

EBITDA calculation is used to understand how profitable a company is before all the non-operational expenses. Investors can easily learn this calculation to help them with the valuation of a company before adding it to their portfolio.

In simple terms, EBITDA is a measure of a company's financial performance, acting as an alternative to other metrics like revenue, earnings, or net income.

It's a way to evaluate a company's performance without having to factor in financing/accounting decisions or tax environments.

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EBITDA Formula

There are two ways of calculating EBITDA using the following formulas:

1. EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation

2. EBITDA = Operating Profit + Depreciation + Amortisation

What is EBITDA Margin?

EBITDA margin is a measurement of a company's EBITDA as a percentage of its total revenue.

EBITDA margin is a company's trailing twelve month EBITDA divided by trailing twelve-month net sales.

Similarly, for calculating quarterly margins, quarterly EBITDA is divided by quarterly sales.

When you want to measure the performance of a company regardless of its financing considerations, tax, or accounting matters, then EBITDA margin is the best measurement to use.

Many investors use EBITDA for getting a closer approximation of performance of the business relative to sales before adjusting for the capital structure of the business.

However, some argue that the exclusion of depreciation expenses fails to capture the ongoing economics of a business. This is because while depreciation expenses are a good proxy for the replacement costs of property, plant, and equipment, they must be paid for in the future to continue business operations.

EBITDA Margin Formula

EBITDA margin is calculated as follows:

EBITDA Margin = EBITDA / Net Sales

Calculating EBITDA Margin - An Example:

Let us see the EBITDA margin calculation of few Indian companies:

The following tables show extracts from income statements of Infosys and TCS.

(All the below mentioned amounts are in millions)

Infosys Ltd

Period 31/12/2018 31/12/2019 31/12/2020
Total Revenue 705,220.00 826,750.00 907,910.00
Finance Cost - - 1,700.00
Tax 42,410.00 56,310.00 53,680.00
Depreciation 18,630.00 20,110.00 28,930.00
Net Income 160,290.00 154,100.00 166,390.00

TCS Ltd

Period 31/12/2018 31/12/2019 31/12/2020
Total Revenue 1,231,040.00 1,464,630.00 1,569,490.00
Finance Cost 520 1,980.00 9,240.00
Tax 82,120.00 100,010.00 98,010.00
Depreciation 20,140.00 20,560.00 35,290.00
Net Income 258,800.00 315,620.00 324,470.00

The following table shows calculation of their respective EBITDA margins:

Ratio 31/12/2018 31/12/2019 31/12/2020
Infosys EBITDA Margin 31% 28% 28%
TCS EBITDA Margin 29% 30% 30%

EBITDA margin for Infosys and TCS for financial year ended 31 March 2020 is worked out as follows:

EBITDA Margin (Infosys)  = 1,700+53,680+28,930+166,390 =  28%
  907,910  

EBITDA Margin (TCS)   = 9,240+98,010+35,290+324,470 =  30%
  1,569,490  

Why is EBITDA Margin So Important?

Knowing the EBITDA margin allows for a comparison of one company's real performance to others in its industry.

This simple measurement can help any investor make quick comparisons across different companies.

EBITDA margin provides us with a measure of how much cash the company is generating per unit revenue.

EBITDA margin is an alternative to net profit margin. Net profit margin includes the effect of depreciation, amortisation, interest expenses as well as tax rates. However, EBITDA margin does not get affected by such expenses where the tax structures are very different.

However, EBITDA margin can be deceptive when applied inaccurately. It is especially unsuitable for firms burdened with high debt. This margin should not be used to compare companies with high debt as their interest expenses will be very high, and EBITDA margins will not capture the interest on the debt.

If you compare two companies, one with low debt and the other one with high debt, the findings may not lead to the correct conclusions.

Also, because EBITDA isn't regulated by GAAP, investors must rely on a company to decide what is and isn't included in the calculation.

Understanding EPS or Earnings Per Share

What is Earnings Per Share?

The term earnings per share (EPS) refers to the amount of net income that has been earned by the shareholders of a company at the end of a period (quarterly or yearly).

In simpler terms, EPS answers a simple question: "how much profit is made for each share?"

Earnings per share is an important financial measure, which indicates the profitability of a company. It is a tool that market participants use frequently to gauge the profitability of a company before buying its share.

EPS assesses the ability of a company to generate net profits for the common shareholders. However, it is not necessary that the company distributes the entire net earnings to the shareholders, it may hold back a part of it to re-invest into the business to induce further growth.

A higher EPS indicates greater value because investors will pay more for a company's shares if they think the company has higher profits relative to its share price.

Calculating EPS

EPS is calculated by dividing the company's net income with its total number of outstanding shares.

Earnings per share can be calculated in two ways:

  • Earnings per share: Net Income after Tax / Total Number of Outstanding Shares
  • Weighted earnings per share: Net Income after Tax - Total Dividends / Total Number of Outstanding Shares

To calculate a company's EPS, the balance sheet and income statement are used to find the total outstanding shares, dividends paid on preferred stock (if any), and the net income or earnings.

For example, if the net profit of a company is Rs 100,000 and the shares outstanding are 2,000 the EPS of the company is Rs 100,000 / 2,000 = Rs 50.

What Makes the EPS Grow?

There can be mainly two reasons why the company's EPS is growing:

  1. Increasing Net Profit: If the company's number of shares outstanding remain same, every time the net profit of the company increases, its EPS will also increase.
  2. Buyback: For the same net profit levels, if the company buys back its shares from the market, EPS will increase. Buying back shares decreases the number of shares outstanding in the market thereby resulting in a higher EPS for shareholders.

Is Every Company with High EPS a Good Buy?

High EPS of a stock is a good thing but high EPS alone does not make a stock good for investing.

What shall be more interesting for investors is a combination of high EPS and low price to earnings ratio (PE ratio).

Along with high EPS, it is also essential to check the quality of EPS. Looking only at high EPS numbers does not say enough about its quality.

Let's understand this with an example.

MRF share price has high EPS numbers. Its trailing twelve month (TTM) EPS is at Rs 2,696.96. Let's check MRF's EPS growth rate over the past 5 years and its dividend payout.

Ratio FY16 FY17 FY18 FY19 FY20
EPS 5,918.50 3,505.20 2,668.90 2,666.50 3,355.10
Dividend per share 100 60 60 60 100
Dividend Payout 1.70% 1.70% 2.20% 2.30% 3.00%

As can be seen above, MRF's EPS has seen a consistent fall in 4 of the last 5 years, which is a concern.

Moreover, if dividend payout ratio is 0%, no matter how high the EPS is, dividend income will still be zero.

So, while screening stocks, one should look at stocks with EPS growth history and ones that are paying dividends.

The quality of EPS gets enhanced when a high EPS company also pays dividends.

Though MRF's EPS is super high, its EPS growth is slow. MRF's dividend payout is also low, but it is consistent.

To know more, you can read MRF's latest result analysis on our website.

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Advantages and Pitfalls of EPS

Investors in the financial world use multiple valuation metrics to value a company's share price and also to compare the valuation of companies in a specific industry.

EPS is an easy way to calculate the earnings of a company. EPS helps investors to know the performance of the company in the specified time.

It is no secret that the earnings a company is able to achieve in a particular year or quarter holds a special place in the hearts of most participants in the stock market.

Predicting next quarter's earnings for a company is one of the hottest topics of discussion (or more aptly - speculation) on 'business' channels.

And if the earnings turn out to be not in line with those 'estimates'...boom! The stock gets a beating on the day of the earnings announcement.

This extreme fixation on the most recent earnings per share of a company, at the cost of ignoring many other aspects of sound evaluation of a business, can be very dangerous to say the least.

As Benjamin Graham once expounded, there are many pitfalls to relying solely on the company's current earnings performance to decide whether or not it is worth investing in.

Some of them are as follows -

  1. Instead of the double test of value provided by evaluating both the earnings and the assets of a company, one would be relying upon a single and therefore less dependable criterion. Even though earnings are important and have their own rightful place, a company's resources still have some significance and require attention.
  2. Second, these earnings statements, on which exclusive reliance has come to be placed, are subject to more rapid and drastic changes from time to time. Much more than those which occur in balance sheets. Due to this, a much higher degree of instability and volatility is introduced into the valuation of stocks. This is painfully evident in the way prices of stocks can change drastically from year to year, or even from day to day, even though actual changes to a business would take much longer and be much more gradual.
  3. Third, the income statements can be much more vulnerable to misleading presentation and mistaken interpretation than is a balance sheet. For example, big changes in extraordinary income or other income whose source is other than from that of the core business of the company can bring in added complexity to the final EPS figure of the company. Thus, many a times giving out a distorted picture of the earnings power of the company. More often than not, this and many other such subtleties go unnoticed. What stands out most prominently is the final EPS figure and its change from the previous year. And that's what ends up having an immediate and strong effect on the price of the stock.

Conclusion

Buying stocks with high EPS ratio is a good first step. But one cannot focus only on high EPS. It is also essential to look at other value indicators to screen stocks further.

There are some important points to keep in mind while selecting high EPS stocks...

Here are some value indicators which might help you shortlist a good stock:

  • Companies which have positive EPS growth in the past
  • Companies with high dividend yield
  • Companies with low P/E Ratio

Suppose there are two companies X and Y, whose EPS is Rs 500 per share. Investors might be tempted to buy these stocks considering their EPS is so high.

Stock X

EPS: Rs 500

Price: Rs 10,000

P/E Ratio: 20

Stock Y

EPS: Rs 500

Price: Rs 15,000

P/E Ratio: 30

In the above example, you can see that for the same EPS numbers, Stock Y is charging a higher price than Stock X.

Hence, lower the P/E ratio, the better valued is the stock.

List of Indian Companies with High Earnings Per Share

Company EPS
MRF 3,355.10
Majesco 841.5
Polson 827.3
Honeywell Automation 556
Shree Cements 425.7
Bharat Rasayan 371
Tide Water Oil 359
Abbott India 279
Tata Chemicals 275
Ruchi Soya 260.8
Atul 224.7
Nestle 204.3
UltraTech Cement 201.5
Sanofi India 196.2
Oracle Financial Services 170.3
Data source: Ace Equity

Recommended Readings on EBITDA Margin and EPS

Here are links to some very insightful Equitymaster articles and videos on EBITDA Margin and EPS

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