Over the last thirty years there has been a strong positive trend in the magnitude of amortization charges, due to both economic and accounting changes. This trend has accelerated since the financial crisis, a period coinciding with a revised accounting treatment for business combinations, which substantially increased the significance of amortization. Concurrent with this trend, companies and external users of financial statements increasingly discuss operating performance focusing on earnings metrics that exclude amortization but include depreciation. This study compares earnings before interest, taxes and amortization (EBITA) with its two more common alternatives—EBIT and EBITDA—in terms of their ability to explain market valuations and predict stock returns. Over the sample period (1987-2016), EBITDA performed better than EBITA, which in turn performed better than EBIT, both in explaining stock prices and predicting stock returns. However, EBITDA’s dominance over EBITA in explaining valuations has been declining over time, while the performance difference between EBITA and EBIT has been increasing. The improvement in the relative accuracy of EBITA-based valuations has been particularly large since the financial crisis and for companies from high amortization intensity industries. Still, focusing on EBITDA when conducting price multiple valuation, which is very common in practice, remains justifiable as this approach continues to generate more precise value estimates compared to EBIT and EBITA based valuations. In terms of ability to predict stock returns, it appears that a structural change has occurred after the financial crisis, as the three operating income measures have failed to consistently predict stock returns over the last seven years.
Columbia Business School Research Paper No. 17-71