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EBIT (Operating Income)

Understand the Concept of EBIT

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EBIT (Operating Income)

In This Article
  • What is the definition of EBIT?
  • What does EBIT stand for and which line items are factored into EBIT?
  • Why is EBIT frequently used for comparisons?
  • How is EBIT different from EBITDA?

EBIT Formula

EBIT, often just referred to as operating income, stands for “Earnings Before Interest and Taxes”.

On the income statement, EBIT is the profit metric that takes into account the following:

  • Revenue: The net sales generated throughout the period.
  • Cost of Goods Sold (COGS): The direct costs incurred in the period (i.e. tied to how revenue is produced).
  • Operating Expenses (OpEx): The indirect costs incurred in the period (i.e. not directly tied to revenue generation, but integral to business operations).

Written out, the formula for EBIT is as follows:

EBIT Formula
  • EBIT = Gross Profit – Operating Expenses

EBIT Calculation Example

For example, let’s say that a company in 2021 has the following financials:

  • Revenue: $25 million
  • COGS: –$10 million
  • OpEx: –$5 million

The gross profit is equal to $15 million, from which we deduct $5 million in OpEx from to calculate EBIT.

  • EBIT = $15 million – $5 million = $10 million

EBIT Margin Calculation Example

Continuing off our previous example, we can divide our company’s EBIT by its revenue to calculate the EBIT margin (i.e. operating margin).

  • EBIT Margin = EBIT / Revenue
  • EBIT Margin = $10 million / $25 million = 40%

Since comparisons of standalone EBIT amounts are not meaningful, standardization is required, which is the purpose of multiples.

In our example, the EBIT margin is 40% — which means that for each dollar of revenue generated, $0.40 is retained and available for non-operating expenses.

The 40% EBIT margin can be compared against that of comparable peers, as well as with historical margins to evaluate the financial performance of the company in question.

Importance of EBIT

The previous calculation of the EBIT margin leads to our next point.

Other than EBITDA, EBIT is likely the most commonly used profitability metric for relative valuation and peer comparisons.

Why? EBIT is unaffected by discretionary decisions, such as:

  • Debt Financing (% of Total Capital Structure — Interest Expense)
  • Non-Core Income Sources (e.g. Interest Income)
  • One-Time Corporate Decisions (e.g. Divestitures, Inventory or PP&E Write-Downs)
  • Taxes (i.e. Jurisdiction Dependent)

All relative valuation is skewed to some extent, but by using an unlevered metric like EBIT, a significant amount of flaws can be avoided.

It is important to note that one of the primary objectives of relative valuation is to compare to the core operations of the comparable companies, as opposed to the non-core operations.

For example, let’s say that there are two companies with net margins of 40% and 20%.

However, the operating margins of the two companies could be much closer, as the cause of the 20% differential might be related to capital structure decisions — i.e. the company with 20% net margins might have undergone an LBO, so incurs substantial interest expense each period.

By comparing the operating margin, these non-core differences are intentionally neglected, to facilitate more meaningful comparisons among peer groups.

EBIT vs EBITDA

To reiterate from earlier, EBIT and EBITDA are two of the most frequently used metrics for peer comparisons.

Like EBIT, EBITDA removes the effect of capital structure decisions and taxes — however, depreciation & amortization is added back since they represent non-cash charges (as well as sometimes stock-based compensation).

EBIT and EBITDA Formulas
  • EBIT = Gross Profit – Operating Expenses
  • EBITDA = EBIT + Depreciation and Amortization (D&A)

EBIT and EBITDA are informative metrics to track a company’s profitability and operational performance.

Hence, both metrics appear in the majority of comps sheets.

EBITDA is typically a larger amount than EBIT because of the non-cash add-backs, with the difference becoming more apparent for capital-intensive industries (i.e. large number of fixed assets + depreciation expenses) — which is an area of frequent criticism.

Another distinction between the two is that operating income (EBIT) is a GAAP metric and appears on the income statement.

On the other hand, EBITDA is a non-GAAP metric and the reconciliation is typically shown separately in SEC filings, as well as used in investor presentations and by equity analysts.

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