I decided to take a closer look at NVIDIA because of its impressive EBITDA numbers and found that this company has a lot going for it. I may buy it. In 2018 the company reported an impressive EBITDA of $4.11 billion. The EBITDA margin was a healthy 35%. You may be saying “that is just great Mark, but what the heck are you talking about?”
If you are an investor you have probably heard the term EBITDA. It is a metric that is used by some investors to evaluate companies. It is commonly used by Private Equity firms when they look for target companies to buy. The term is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization.
To understand EBITDA we need to understand what net income is. Net Income is simply the amount of sales a company makes minus the costs it incurs. When you hear an analyst talk about earnings per share, it is the net income divided by the number of shares. For example, if a company has a net income of $1 million and has one million shares outstanding it will report an earnings per share of $1.
The costs of a company include the cost of the goods that were sold and the selling, general, administrative, and operational costs associated with the sales. They also include the non-operational costs such as interest payments on the bonds the company has issued, the taxes it must pay, and the relevant depreciation and amortization costs. EBITDA can be thought of as net income without deducting the non-operating costs. This may sound complicated but comes from a simple concept.
EBITDA became a popular measure in the 1980s when corporate raiding and hostile takeovers were common. When this happens the buyer, or raider, attempts to takeover a company without the approval of the management by acquiring enough shares to gain control. This was typically done with borrowed money. EBITDA was a measure that was used to see if the cash flow that the target company generated would cover the interest costs of the money that was borrowed to buy it.
A good analogy for why these raiders cared about EBITDA is rental property Suppose you buy a building and that the rental income you make covers the cost of your expenses. Then in theory the investment will eventually pay for itself. This was the principle behind the hostile takeovers.
EBITDA should not be used in isolation because non-operating costs are still costs and eventually they need to be paid. This number can be very misleading. A company that is effectively bankrupt because it owes millions in back taxes could have great EBITDA. As a matter of fact, like many other companies NVDA doesn’t even report EBITDA in their financial statements.
EBITDA aside, there are three things that I believe indicate that NVDA may potentially be a profitable long-term investment. First, the operating margins have expanded. Operating margins are how much money a company makes for each dollar of sales expressed as a percentage. Over the past three years the margin has expanded from 22% to 37%. In other-words, the company was making 22 cents per dollar and now they are making 37 cents per dollar. This is very impressive growth.
The second thing that may be bullish for NVDA is the increasing amount of free cash flow that it has been generating. This is the amount of cash that a company has after paying its bills. In 2016 is was $1.1 billion. By 2018, this number had increased to $2.9 billion. This is also an impressive growth rate.
The third aspect of NVDA that I find impressive is the growth in earnings per share. In 2018 they were $1.08, in 2017 they were $2.57, and 2018 they increased to $4.82.