What is EBIT?
EBIT stands for “Earnings Before Interest and Taxes” and measures a company’s operating profitability in a period after COGS and operating expenses are deducted.
How to Calculate EBIT (Step-by-Step)
On the income statement, operating income takes into account the following line items:
- 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).
Understanding the meaning of revenue (the “top line) should be relatively straightforward because it represents the net sales earned by a company from its operations, i.e. selling products and services to customers.
As for cost of goods sold (COGS) and operating expenses (OpEx), the distinction was mentioned earlier, where the former consists of direct costs while the latter comprises indirect costs.
But the matter of importance here is that COGS and operating expenses (OpEx), such as selling, general and administrative (SG&A), research and development (R&D) and sales and marketing (S&M) are incurred as part of the company’s core operations.
In other words, all expenses above the operating income line item are deemed “operating costs” while those below the line such as interest expense and taxes are “non-operating costs”.
Written out, the formula for calculating a company’s operating income (EBIT) is as follows:
- Gross Profit = Revenue – Cost of Goods Sold (COGS)
- Operating Expenses = Σ Indirect Operating Costs
A company’s revenue is the starting line item on the income statement, while COGS is the first deduction from the “top line”, resulting in a company’s gross profit.
From a company’s gross profit, the next step is to subtract its operating expenses to arrive at the operating income line item. The composition of a company’s operating expenses will vary by the specific circumstances (e.g. industry, cost structure), but the more common operating expenses are the following:
- Selling, General and Administrative (SG&A)
- Research and Development (R&D)
- Sales and Marketing (S&M)
- Advertising Spend
EBIT Calculation Example
For example, let’s say that a company in 2021 has the following financials:
- Revenue = $25 million
- COGS = –$10 million
- Operating Expenses = –$5 million
The gross profit is equal to $15 million, from which we deduct $5 million in OpEx to calculate operating income.
- Operating Income = $15 million – $5 million = $10 million
EBIT Margin Calculation Example (%)
Continuing off our previous example, we can divide our company’s operating income by its revenue to calculate the operating margin.
Since the operating income is $10 million, we’ll divide that profit metric by our revenue of $25 million.
- Operating Margin = $10 million ÷ $25 million = 40%
Since comparisons of standalone operating profit amounts are not meaningful, standardization is required, which is the purpose of multiples.
In our example, the operating margin is 40% — which means that for each dollar of revenue generated, $0.40 is retained and available for non-operating expenses.
The 40% 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.
What is a Good EBIT?
The previous calculation of the EBIT margin leads to our next point.
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 the core operations of 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.