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    EBT, EBIT, EBITDA: Will the Real Earnings Figure Please Stand Up?

    by John Bajkowski

    Earnings are the premier financial figure that help investors judge a company’s bottom line and often form the basis for determining the company’s true value or worth. However, if you have picked up a recent annual report or come across a quarterly earnings announcement, chances are that it is filled with a wide array of earnings figures with cryptic and confusing titles.

    In an effort to put their best foot forward, companies have moved away from emphasizing earnings determined through generally accepted accounting principles (GAAP) and instead have tried to force the focus on earnings figures described as pro forma, normalized, or cash-based. In particular, earnings before interest, taxes, depreciation and amortization, or EBITDA, has frequently been put forth as the best way to measure performance given a company’s unique circumstances. However, EBITDA figures also typically report performance in a favorable light.

    While all of these measures have their purpose, it is necessary to examine the complete income statement to understand the adjustments and assumptions built into these alternative earnings measures.

    Income statement

    The goal of the income statement is to determine revenue for the period that it covers and then to match the corresponding expenses to the revenue. The income statement, sometimes referred to as the statement of earnings or statement of operations, presents a picture of a company’s profitability. The income statement, is designed to be read from top to bottom. Like all financial statements, it reflects management’s decisions, estimates, and accounting choices. Table 1 presents the 2001 income statement for AOL Time Warner, while Table 2 presents highlighted elements used by management to describe its performance. A step-by-step review of the major elements of the income statement will illustrate the calculation and use of both traditional GAAP and alternative measures of earnings.

    TABLE 1. AOL Time Warner Consolidated Statement of Operations

    Year Ended December 31,
    (millions, except per share amounts)

      2001
    Revenues:
       Subscriptions $16,543
       Advertising and commerce 8,487
       Content and other 13,204
    Total revenues 38,234
    Cost of revenues (20,704)
    Selling, general and administrative (9,596)
    Amortization of goodwill and other intangible assets (7,231)
    Merger-related costs (250)
    Operating income (loss) 453
    Interest income (expense), net (1,379)
    Other income (expense), net (3,539)
    Minority interest expense (310)
    Income (loss) before income taxes (4,775)
    Income tax provision (146)
    Net income (loss) (4,921)
    Basic net income (loss) per common share $ (1.11)
    Diluted net income (loss) per common share $ (1.11)

    Revenue

    The income statement and balance sheet are constructed using accrual, not cash, accounting. Revenues and expenses are recorded when they are earned and incurred regardless of whether the cash has been received or paid. Revenue should only be recorded once the exchange of goods or services has taken place and the sale has been completed. Expenses should be recorded when the goods and services that generate expenses are used. Note that sales and revenue are the same thing and are considered the “top line” of the income statement.

    AOL Time Warner is a media firm with a wide range of business lines—America Online, cable television, film entertainment, television and cable programming, music publishing, and print publishing. In presenting its income statement, revenue is divided into subscriptions, advertising and commerce, and content. Net revenue for AOL Time Warner is reported as $38,234 million.

    Gross Income

    Subtracting the cost of revenues (or cost of goods sold) from the net sales revenue produces gross income (or gross profit). This is the first income step and indicates the profitability before operating, financial, and tax expenses are considered. The cost of revenues item indicates the cost to produce the goods sold and includes any raw materials and labor costs accrued in creating the finished good or service. The nature and efficiency of the product’s manufacturing cycle will greatly affect the gross income. The cost of revenue is often a substantial line item for traditional manufacturers, wholesalers, and retailers. Companies have some discretion on the accounting method used to determine the cost of inventory sold, and any changes to the methods must be disclosed in the notes accompanying the financial statements.

    AOL Time Warner reported cost of revenue totaling $20,704 million in 2001, resulting in gross income of $17,530 million. The gross margin for AOL Time Warner is 45.8% (gross income divided by revenue), meaning every dollar in revenue resulted in almost 46 cents of gross income.

    Operating income—EBIT

    Subtracting operating expenses from gross income provides the next primary income step—operating income. Operating income or earnings before interest and taxes (EBIT) represents income generated for the period after all costs except for interest, taxes, non-operating costs, and extraordinary charges.

    Operating expenses are diverse and may include advertising, selling and administrative expenses, depreciation, research and development, maintenance and repairs, and even lease payments. Items such as research and development are only required to be listed as separate line items if they represent a significant and material value.

    AOL groups most of these items into its selling, general and administrative line item, including depreciation. When a company makes a capital investment, an asset is created on the balance sheet and the cost of the asset is then depreciated over its useful life. Depreciation is an operating expense on the income statement. It reduces reported taxable income, although it does not actually represent the use of cash. The notes to the financial statement describe the depreciation elements.

    AOL’s purchase of Time Warner resulted in a significant creation of the intangible asset of goodwill. Goodwill is the excess of the price paid for a company over the sum of the fair market value of the net assets of the company. The amortization of this goodwill was $7,231 million in 2001 for AOL Time Warner—significantly impacting operating income and the bottom line earnings. New accounting rules go into effect this year that do away with amortization of purchased goodwill and instead require management to judge the impairment of this asset and make corresponding adjustments. AOL Time Warner expects to take a one-time, non-cash charge of $54 billion for its goodwill in 2002.

    Overall, operating income reflects the organizational and productive efficiency of the firm before considering how the firm was financed or the contribution (or drag) of non-business activities. This is also referred to as core operations.

    The reported operating income for AOL Time Warner was $453 million, resulting in an operating margin of only 1.2%. Clearly, non-cash expenses had a significant impact on reported operating income.

    EBITDA

    Earnings before interest, taxes, depreciation and amortization (EBITDA) has become a popular figure in determining the value of capital intensive firms such as cable and communications companies. The high annual and quarterly depreciation rates of their capital investments, coupled with high interest payments of debt used to finance their investments often left them with negative earnings—making valuation analysis more difficult. EBITDA figures report the earnings available for debt payments and place them high enough in the income statement to create positive figures necessary for valuation models.

    EBITDA analysis has grown in popularity among companies that expand through the buyout of other firms. In the past, the purchase of a firm would create the intangible asset of goodwill that would be slowly amortized—reducing reported earnings even though no cash was actually being used. A J.P. Morgan study indicates that EBITDA figures show up in 75% of all research reports.

    EBITDA ignores depreciation and amortization because they are non-cash expenses. Taxes and interest are ignored because proponents argue that these elements are not related to the company’s core line of business. EBITDA can help to show earnings available to support and pay off debt.

    While some investors equate EBITDA to cash flow, it is based upon the income statement and therefore relies on accrual, not cash, accounting. The actual statement of cash flows does a better job of examining actual cash flow from operations, investing, and financing during a given period.

    The reported EBITDA for AOL Time Warner is $9,656 million. This number is not found in Table 1, the income statement. AOL Time Warner provides a number of summary tables in its annual report that focus on additional measures of company performance. These are highlighted in Table 2. To calculate this figure, the cash flow statement must be examined to reveal total depreciation and amortization expense of $9,203 million. The income statement only presents the $7,231 million amortization expense of goodwill. Adding the operating income of $453 million to the depreciation and amortization expense of $9,203 results in the $9,656 EBITDA figure.

    TABLE 2. AOL Time Warner Company Highlights

    Year Ended December 31
    (millions, except per share amounts)

      Reported Normalized
      2001 2001
    Revenues:
       Subscriptions $16,543 $16,543
       Advertising and commerce 8,487 8,487
       Content and other 13,204 13,204
    Total revenues $38,234 $38,234
    EBITDA 9,656 9,906
    Depreciation and amortization (9,203) (9,203)
    Operating income (loss) 453 703
    Pretax income (loss) (4,775) (1,993)
    Net income (loss) (4,921) (3,251)
    Basic net income (loss) per common share $(1.11) $(0.73)
    Cash earnings per share $(0.57) $ (1.18)

    Non-Operating Expenses

    Interest expense includes interest paid by the firm on all outstanding debt and may also include loan fees and other related financing costs. The special nature of interest leads to separate reporting. Interest is a financial cost, not an operating cost. Interest cost is dependent upon the financial policies of the firm without regard to nature or efficiency of the firm’s operation. AOL Time Warner recorded $1,379 million in interest expense. Separately, AOL Time Warner reported $310 million in interest expense for investments in which they have a minority equity interest.

    If the company had additional non-operating expenses or profits, they would also be listed after the operating expenses, but before the tax liabilities. Common elements include interest income from investments and gain or loss from the sale of assets. These are items not related to the sales revenue activity of the firm and need to be tracked separately to measure their impact on bottom line income. AOL Time Warner had significant losses from other investments totaling $3,539 million in 2001. This loss includes investment losses and write-downs of investments in Time Warner Telecom and Columbia House.

    Subtracting non-operating expense from operating income leaves income or earnings before taxes (EBT). This step accumulates all revenue and expenses with the exception of a potential tax liability. AOL reports a loss of $4,775 million before taxes. Income Tax

    The income tax expense lists the federal and state tax liability incurred by the firm. Other types of taxes, such as property and Social Security, appear under operating expenses.

    Note that companies usually maintain separate accounting books for tax reporting purposes. Taxes are paid on income, so companies try to keep profits as low as possible to minimize their tax liability when reporting to the IRS. While generally accepted accounting principles must be followed for both sets of books, differences can arise in the calculation of tax liabilities between the accounting statements prepared for the IRS and those presented to investors.

    The income tax provision reported by AOL Time Warner was $146 million in 2001. A supplement to the financial statement indicates that the company actually paid $340 million in taxes during 2001.

    Net Income

    Net income or earnings is the bottom-line figure that attracts the most attention. Usually, however, it is tracked in a different format, as earnings per share. The earnings per share figure (basic earnings per share) is simply the net income of the firm, less any preferred dividend payments, divided by the average number of common shares outstanding during the period. If a company has convertible bonds or stocks, stock options, and warrants, it must also calculate a diluted earnings per share, which measures the impact on earnings per share created by the conversion and exercising of all of these securities into common stock. Both the basic and fully diluted earnings per share must be reported in the income statement. The same line item may be labeled basic and diluted if the company has no convertible securities. The notes to financial statements should include a table describing the calculation of basic and diluted earnings per share.

    Even though AOL Time Warner has a significant number of outstanding options, they are currently treating them as non-dilutive because they are exercisable above the stock’s current market price. The basic and diluted earnings per share figure is therefore the same—a loss of $1.11.

    Adjustments to Income

    Subtracting the income tax expense from income before taxes produces aftertax income. For most firms this figure will also be the net income. However, there are three notable items that may be listed after taxes—extraordinary items, discontinued operations, and cumulative effect of change in accounting.

    Extraordinary items are distinguished by their unusual nature and by the infrequency of their occurrence. An uninsured loss from an earthquake would qualify as an extraordinary item. The event should not be related to the firm’s normal course of business.

    The discontinued operations line can detail the gain or loss from the disposal of a segment of a firm’s business or the shutdown of a line of business.

    As companies adapt new accounting policies or make corrections to past financial statements, there may be the need to take a special one-time, non-cash charge. This charge would be reflected in the line item “cumulative effect of change in accounting” and described in the notes.

    Investors need to be aware of management’s propensity to determine these types of adjustments. Management has control over factors such as the timing of selling a business or closing down a line. Some firms have shown a tendency to bunch up adjustments to clear the slate for future profits. When earnings are expected to be weak during a particular period, there may be a push to take a “big bath.” When new management takes over a company, there is also a strong temptation to write-off old projects and assets to show strong improvements during future periods.

    The Securities and Exchange Commission has warned companies reporting charges that it will examine the charges closely and has reiterated the disclosure requirements for justifying and explaining the determination of each charge.

    While AOL Time Warner had a number of one-time charges during 2001, they were reported primarily in the other loss line. In a separate statement, AOL Time Warner presented normalized earnings that adjust for these non-recurring items. These normalized earnings or results are adjusted to ignore the impact of significant and unusual non-recurring items. The purpose of normalizing results is to more directly examine the production of core operations and track underlying trends in operating results. As indicated in Table 2, the normalized net income is increased by $1,670 million in 2001. Pretax adjustments totaled $2,782 million and consisted of merger-related costs and loss on writedown of investments. Higher profits would result in higher taxes; the tax impact of these adjustments is $1,112 million (not shown). The normalized loss in 2001 is $3,251 versus the reported loss of $4,921 million. On a per share basis, normalized earnings per share improved by 38 cents.

    A number of data vendors also present normalized earnings, but the adjustment assumptions vary from vendor to vendor. Multex reports normalized 2001 earnings per share for AOL Time Warner as a 1.3 cent loss, while Value Line reports a 74 cent loss—all normalized earnings, all technically correct, yet all different. When working with non-GAAP figures it is best to stick with one data source so the same types of assumptions and rules are applied.

    Cash Earnings

    The final earnings figure presented by AOL Time Warner in its company highlights segment is cash earnings per share. Some firms label this figure pro forma earnings. A note with the company’s earnings announcement defines this figure as pretax income excluding the effect of non-cash amortization expense, less cash paid for taxes, divided by the weighted average shares outstanding on a fully diluted basis. The math begins with the pretax loss of $4,775 million, adds back $7,231 in amortization from operations and $495 in amortization of equity investments, and subtracts $340 in cash taxes paid to determine basic cash earnings of $2,611 million. Normalized cash earnings adds back an additional $2,782 million in a pretax adjustment discussed in the previous section to come up with normalized diluted cash earnings of $5,393 million. Dividing these figures by the number of outstanding shares on a diluted basis leads to cash earnings of $0.57 and normalized cash earnings of $1.18.

    Cash, or pro forma, earnings attempts to illustrate the impact of amortization on the bottom-line earnings and equate firms with and without large amortization charges. The use of the term “cash,” however, is confusing and this figure should not be considered a substitute for actual cash flow.

    Conclusion

    With all of the different types of earnings figures presented by a company, the question comes to: Which one is best?

    Unfortunately, there is no clear-cut answer. GAAP-derived basic and diluted earnings per share are most comparable from company to company. However, there are many management judgments, estimates, and choices of accounting methods that affect even the GAAP earnings, so it is important to be aware and alert to these issues when judging the quality of the firm’s earnings.

    Traditional valuation measures rely on the value and growth of variables such as basic earnings and dividends. However, the lack of true bottom-line profitability or dividend payments prevents the valuation of companies such as AOL Time Warner.

    Companies report figures such as EBITDA or normalized earnings because they are more favorable. These measures have their value, especially when applied consistently across a given industry. But they must still be examined in the context of all three financial statements.

    Keep in mind, too, that no single year will capture the dynamics of the firm. A careful comparison of changes and an identification of trends is critical in any fundamental analysis of a firm.

       Common Earnings Terms and What They Include
    Earnings before interest and taxes (EBIT), or operating income: Sales less all operating expenses. Highlights the relationship between sales and management-controllable costs before interest, taxes, and non-operational expenses.

    Earnings before interest, taxes, depreciation and amortization (EBITDA): Usually calculated by adding amortization and depreciation expenses to operating income. Best used to compare companies in a given industry with widely different capital structures, tax rates, and depreciation schedules. Helpful in measuring growth companies spending cash on building out their operations. Also can provide a basic measure of a firm’s ability to generate cash to meet interest payments. However, EBITDA ignores the impact of depreciation, thereby overstating profits and failing to consider the capital needed to reinvest in a business. When compared to operating cash flow, it ignores changes in working capital. Can be manipulated through aggressive accounting policies related to revenue and expense recognition.

    Net income or earnings: Sales less operating expenses, interest, taxes, and other expenses. Net income is the “bottom-line” figure that indicates how well management has been able to turn revenues into earnings available for shareholders. However, there are many management judgments, estimates, and choice of accounting methods that affect net income.

    Basic earnings per share: Income available to common stockholders divided by the weighted average number of common shares outstanding during the reporting period. Bottom-line earnings per share figure generally reported for a company and used in the calculation of the price-earnings ratio.

    Diluted earnings per share: Income available to common stockholders adjusted for interest and tax impact of converted shares divided number common shares outstanding plus converted shares. Captures the impact on basic earnings per share if outstanding convertible securities and stock options were actually converted into common stock. Examples of convertible securities include stock options, convertible bonds and convertible preferred stock. With a larger number of outstanding shares, a given level of income would reduce or dilute earnings for a given share. If there are no convertible securities, basic earnings per share and diluted earnings per share will be the same. However, if a company has convertibles, the diluted earnings per share will be less than the basic earnings per share.

    Normalized earnings: Earnings adjusted to ignore the impact of significant and unusual non-recurring items. Normalized earnings more directly examine the profitability of core operations and underlying trends. Exact adjustments for normalized earnings vary by company and reporting service. Earnings estimates are often based upon normalized fully diluted earnings per share.

    Cash earnings, or pro forma earnings: Usually calculated by adding non-cash amortization expenses back to net income. Helps to make the earnings of firms with significant amortization comparable with other firms. However, calculations must be checked to ensure that pro forma earnings are calculated with the same assumptions and adjustments.


    John Bajkowski is AAII’s financial analysis vice president and editor of Computerized Investing.


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