Page 166 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 5: Equity Valuation Models

cash flow. These earnings measure is of particular interest in cases where companies have Notes
large amounts of fixed assets which are subject to heavy depreciation charges (such as
manufacturing companies) or in the case where a company has a large amount of acquired
intangible assets on its books and is thus subject to large amortization charges (such as a
company that has purchased a brand or a company that has recently made a large
acquisition). Since the distortionary accounting and financing effects on company earnings
do not factor into EBIDTA, it is a good way of comparing companies within and across
industries. This measure is also of interest to a company's creditors, since EBIDTA is
essentially the income that a company has free for interest payments. In general, EBIDTA
is a useful measure only for large companies with significant assets, and/or for companies
with a significant amount of debt financing.
EBIDTA is rarely a useful measure for evaluating a small company with no significant
loans. While EBITDA can be used to analyze and compare profitability between companies
and industries, investors should understand that there are serious limits to what the
metric can tell them about a company.

Calculating EBIDTA

(a) Calculate net income: To calculate net income obtain total income and subtract total
expenses. Total income is defined as the amount of money obtained for services,
labor or the sale of goods. Total expense is defined as when a corporation uses up an
asset or incurs a liability.
(b) Determine income taxes: Income taxes are the total amount of taxes paid to federal,
state and local governments.
(c) Compute interest charges: Interest is the fee paid to companies or individuals that
reimburses the individual or companies for the use of credit or currency.

(d) Establish the cost of depreciation: Depreciation is the term used to define a cash (machines
or property) or non-cash asset (a copyright, a trademark or brand name recognition)
that loses value over time whether through aging, wear and tear or the assets
becoming obsolete. There are two methods of depreciation: straight line and
accelerated.
(e) Ascertain the cost of amortization: Amortization is a method of decreasing the amounts
of financial instruments over time including interest other finance charges.

(f) Add all previously defined components: EBITDA equals amortization plus depreciation
plus interest plus net income plus income taxes. The resulting figure is then subtracted
from total expense. This final figure is then subtracted from total revenue to arrive
at EBITDA.

5.5 Summary

Determining the total value of a company involves more than reviewing assets and revenue
figures.
An equity valuation takes several financial indicators into account.
These include both tangible and intangible assets, and provide prospective investors,
creditors or shareholders with an accurate perspective of the true value of a company at
any given time.

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