What exactly does the EBITDA margin tell investors about a company?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. EBITDA margins provide investors a snapshot of short-term operational efficiency. This measure is similar to other profitability ratios, but it can be especially useful for comparing companies with different capital investment, debt and tax profiles. EBITDA is also important to consider in the case of acquisition targets.

EBITDA is sometimes reported in quarterly earnings press releases and is frequently cited by financial analysts. Ignoring tax and interest expenses allows analysts to focus specifically on operational performance. Depreciation and amortization are noncash expenses, so EBITDA also provides insight into approximate cash generation and operations controlled for capital investments. Margins measure income generation relative to revenue and are used to assess operational efficiency. Acquisitive companies often focus on the income and cash generation potential of acquisition targets. EBITDA is, therefore, a useful tool for evaluating how a business portfolio may function when tucked into the overall operations of a larger firm.

Investors must be wary of valuations that rely too heavily on EBITDA. Generally accepted accounting principles, or GAAP, do not include EBITDA as a profitability measure, and EBITDA loses explanatory value by omitting important expenses. Investors must consider net income, cash flow metrics and financial strength to develop a sufficient understanding of fundamentals.

Consider Cree, Inc's (Nasdaq: CREE) 2014 Form 10-K. Cree recorded revenue of $1.648 million and operating income of $134 million in the full year 2014, meaning operating margin was 8% in this period. EBITDA was $287 in 2014 and EBITDA margin was 18%. These margins can be compared to those of competitors like OSRAM to measure the relative operating efficiency of the businesses. OSRAM recorded a EBITDA margin of 11% in 2014. Investors should note that Cree will likely continue incurring a tax expense and capital investments are necessary to the maintenance of the firm.