EBIT vs. EBITDA - which is More Common for the DCF Model?

Evaluating companies using the DCF (Discounted Cash Flow) method requires capitalizing the Free Cash Flows to the firm (FCFF) at the appropriate discount rate. - the weighted average cost of capital (WACC).

This article will discuss two accounting terms used to build the FCFF - EBIT and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). We will deal with the definitions of the two - and see which is more beneficial for calculating the FCF.

Both EBIT and EBITDA are indicators of the firm's profitability.

What is EBIT?

EBIT stands for Earnings Before Interest and Taxes.

EBIT is net Income excluding the effect of debt interest and taxes.

The formula for the EBIT is:

EBIT = Sales Revenue - Cost of goods sold (COGS) - Operating Expenses

Where:

• Sales revenue is the Income received by a company from its sales of goods or the provision of services.
• The Cost of Goods Sold (COGS) is the direct cost of making a company's products.
• Operating Expense is an expense a business incurs through its normal business operations.

Alternatively, if one starts from the bottom of the profit and loss statement, it is defined as:

EBIT = Net Income + Interest + Taxes

Where:

• Net Income – also called net earnings, is sales minus the cost of goods sold, general expenses, taxes, and interest. It's the bottom line of the profit and loss statement.
• Interest – Since any business with debts to pay will have some interest expense. Adding back a business’s interest expense allows the new owner to choose if they’ll use debt to buy the company and negotiate their terms.
• Taxes – the amount of the firm's income paid to the government. 

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

The formula used to calculate EBITDA is:

EBITDA = EBIT + Depreciation + Amortization

• Depreciation - how much of an asset's value has been used. Depreciation is the process of deducting the cost of a business asset over a long period rather than over one year. The amount depreciated is called Depreciation.
• Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period.

Depreciation and amortization are added because they are non-cash deductions, and whoever buys your business will have their depreciation and amortization schedules.

FCFF

Free Cash Flows to the firm (FCFF) denotes the amount of cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments.

The two common definitions for FCFF are:

Definition 1:

FCFF=(EBIT×(1−TR))+D−LI−IWC

where: EBIT=Earnings before interest and taxes

D=Depreciation​

​

TR=Tax Rate

LI=Long-term Investments. These are investments in the firm's fixed assets, that is, in assets that help generate the firm's income.

IWC=Investments in Working Capital. 

Working Capital is equal to:

Current Assets - Current Liabilities.

The investment in working capital equals the increase of working capital in a specific year relative to the previous year. 

Definition 2:

FCFF=(EBITDA×(1−TR))+(D×TR)-LI - IWC

EBIT vs EBITDA - Which is More Common for the DCF Model?

In the previous section, we presented the two standard definitions of the FCFF. Which is more common in business valuation, you ask? The answer is - Definition 1.

Example

Conclusion

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