To illustrate, let's consider a company that buys a $100 data centre every 10 years. (To keep things simple, let's assume the data centre is worthless after 10 years.) The data centre generates $20 in revenues for each of those 10 years.
Instead of showing an $80 loss in year 1 and then a $20 profit in years 2 through 10 (with the expectation of another $80 loss in year 11), accountants smooth the numbers based on expectations. The $100 data centre cost is "depreciated" over the expected lifetime of the asset. So one might account $10 of the data centre's cost to each of its ten years, thereby producing $10 of profit each year. This better reflects economic reality.
Ebitda does not include depreciation. The aforementioned company's Ebitda would be $20 for years 2 through 10. This is a small problem in year 2. But if you're an investor in year 10, ignoring that depreciation is the flip side of capital expenditure, you're in for a nasty shock when year 11's predictable capital expenditure comes down the line.
This is correct - good explanation. It's also why good financial professionals/investors look at cash flow statement (follow the money) more so than the income statement.
The whole idea of depreciation is spreading large capital expenditures (free cash flow = cash flow from operations - cap. ex.) over many years.
Therefore, free cash flow in any single year does not say much, only when considered over many years.
The key question is, then, those large capital expenditures that are accounting for the large depreciation charges, were they truly one-off, or can we expect them to be recurring?
Having said that, I have made mucho dinero off of investing in companies that have negative earnings due to high depreciation charges from truly one-off expenses (infrastructure investment, foolish purchases by previous management, etc.). Eventually the depreciation tapers off and earnings fall in line with fcf, and I make money.
EBITDA is Earnings Before ITDA. Quick example, with super simple math:
Scenario A (AWS)
- Over 5 years, you bring in $1M per year in revenue
- Every year you pay $200k in AWS fees
- Your earnings (Net Income) are $800k per year, your EBITDA is $800k per year
Scenario B (Buy your own hardware)
- Over 5 years, you bring in $1M per year in revenue
- You pay $1M in year one for hardware and depreciate it over the next 10 years at $100k per year
- Your earnings (Net Income) are $800k per year, your EBITDA is $900k per year
There are a ton of nuances to this, but this is generally how it works. As you can see the depreciation schedule affects this a lot, as well as when you choose to make the investment. Hence why it's feasible that Dropbox took out it's largest operating expense, i.e. AWS storage, which literally overnight increased EBITDA. It just so happens to be that a year ago they switched over to their own data center, and now they are touted "EBITDA profitable".
Long story - these stories are kinda stupid unless you get to see the full income statement, balance sheet and cash flow statement.
To illustrate, let's consider a company that buys a $100 data centre every 10 years. (To keep things simple, let's assume the data centre is worthless after 10 years.) The data centre generates $20 in revenues for each of those 10 years.
Instead of showing an $80 loss in year 1 and then a $20 profit in years 2 through 10 (with the expectation of another $80 loss in year 11), accountants smooth the numbers based on expectations. The $100 data centre cost is "depreciated" over the expected lifetime of the asset. So one might account $10 of the data centre's cost to each of its ten years, thereby producing $10 of profit each year. This better reflects economic reality.
Ebitda does not include depreciation. The aforementioned company's Ebitda would be $20 for years 2 through 10. This is a small problem in year 2. But if you're an investor in year 10, ignoring that depreciation is the flip side of capital expenditure, you're in for a nasty shock when year 11's predictable capital expenditure comes down the line.