What Is Adjusted EBITDA and Why It Matters to Investors

EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. At its core, EBITDA is a measure of a company’s operating profitability before factoring in financial expenses (interest), government obligations (taxes), and non-cash charges (depreciation and amortization).

Think of it like this: EBITDA isolates a company’s performance from its capital structure (how it’s financed with debt and equity) and its tax environment. It answers the question, “How profitable is this company’s core business, regardless of its debt, tax rate, or accounting decisions?”

EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation + Amortization

This metric is incredibly useful for comparing companies in the same industry. For example, two manufacturing firms might have vastly different debt loads or tax rates, making their net incomes difficult to compare. By using EBITDA, you can get a better “apples-to-apples” comparison of their operational efficiency.

While EBITDA is a great tool, it has a significant limitation: it still includes a variety of unusual, one-time, or non-recurring items that can distort a company’s true earning power. These items are often called “add-backs” because they are added back to the standard EBITDA calculation.

Adjusted EBITDA is a modified version of EBITDA that removes these irregular items. Its purpose is to present a normalized and sustainable view of a company’s earnings. This is particularly crucial when a company is being valued for a sale, merger, or acquisition. A private equity firm, for instance, wants to know what a company’s earnings will look like under their ownership, without the one-off costs or benefits from the past.

So, what kinds of things get adjusted? The specific items can vary, but they generally fall into a few key categories:

• Non-Recurring or One-Time Expenses: These are expenses that are not expected to happen again in the future. Examples include a major legal settlement, costs associated with a corporate restructuring, a one-time severance package for a terminated executive, or moving expenses for a new office.
• Non-Operating Income or Losses: This includes gains or losses from activities that are not part of a company’s core business. A company that makes widgets but earns a one-time gain from selling an old piece of property would adjust for that gain, as it isn’t related to its core widget-making business.
• Owner-Specific Expenses (in Private Companies): This is a critical adjustment, especially for valuing smaller, privately held businesses. It can include an owner’s salary that is significantly above or below market rate, personal expenses (like travel or vehicles) run through the business, or above-market rent paid to an owner-controlled entity. The goal is to normalize these expenses to what a new, professional owner would reasonably incur.
• Stock-Based Compensation: This is a non-cash expense that can significantly impact a company’s reported earnings. Since it doesn’t represent an actual outflow of cash in the period it’s expensed, many analysts add it back to get a clearer picture of cash-based profitability.

Adjusted EBITDA = EBITDA + One−time Expenses − One−time Gains + Other Adjustments

To understand the power of Adjusted EBITDA, let’s look at a hypothetical example.

Imagine you are a private equity investor looking to acquire one of two competing companies, “Company A” or “Company B.”

• Company A has an EBITDA of $10 million. The company’s management, however, points out that they had to pay a one-time legal settlement of $2 million this year, which won’t happen again. They also spent $1 million on a new marketing campaign that is a recurring expense, not a one-time one.
• Company B also has an EBITDA of $10 million. The management team notes they had a one-time gain of $2 million from selling an old warehouse and an excess owner’s salary of $1 million that would be eliminated under new ownership.

At first glance, with an identical EBITDA, they seem similar. However, a deeper look with Adjusted EBITDA reveals a very different story:

• Company A’s Adjusted EBITDA:
  • $10 million (EBITDA) + $2 million (Legal Settlement) = $12 million
• Company B’s Adjusted EBITDA:
  • $10 million (EBITDA) – $2 million (Gain from Asset Sale) + $1 million (Excess Owner’s Salary) = $9 million

By calculating the Adjusted EBITDA, you see that Company A’s core earnings power is actually stronger than Company B’s. This normalized figure allows the private equity firm to value Company A more accurately, as its underlying business is more profitable without the distorting one-time events.

This is why Adjusted EBITDA is so critical in mergers and acquisitions, and why it’s a metric you’ll often see highlighted in investor presentations—especially from companies that are being valued for a potential sale or are seeking new capital.

For the individual investor, Adjusted EBITDA is a double-edged sword. When used responsibly, it can provide invaluable insights. When used improperly, it can be a tool for manipulation.

• Clarity on Core Performance: Adjusted EBITDA helps you filter out the “noise” of one-time events to see the true earning power of the underlying business. This is particularly useful for volatile or high-growth companies.
• Better Comparability: By normalizing for one-time costs and accounting differences, you can more effectively compare the operational efficiency of different companies within the same industry.
• Insight into Valuation: Since this metric is a primary driver for professional valuations, understanding it helps you think like a professional analyst and better assess a company’s fair value, especially in the context of a potential acquisition.

• It’s a Non-GAAP Metric: Unlike Net Income, Adjusted EBITDA is not regulated by Generally Accepted Accounting Principles (GAAP). This means companies have significant discretion over which items they choose to “add back.”
• The “WeWork” Problem: The infamous example of WeWork’s “Community-Adjusted EBITDA” serves as a powerful cautionary tale. The company’s management created a bespoke metric that stripped out virtually all its operating costs, painting a misleadingly rosy picture of its financial health.
• Masking Underlying Weakness: The biggest danger is when companies use repeated “one-time” adjustments to mask underlying, recurring weaknesses. For example, if a company has “restructuring costs” year after year, those costs aren’t truly one-time—they’re a part of doing business.

As an investor, you should never take Adjusted EBITDA at face value. Instead, use it as a starting point for further analysis.

• Read the Footnotes: Always cross-reference the adjusted figure with the company’s official financial statements. The company must disclose the specific adjustments it made.
• Scrutinize the Adjustments: Ask yourself: are these adjustments truly non-recurring? Are they legitimate one-time costs, or are they expenses that should be a part of the business’s normal operations?
• Compare It to Other Metrics: Don’t rely on Adjusted EBITDA alone. Compare it to other key metrics like operating cash flow, net income, and free cash flow to get a comprehensive view of the company’s financial health.

Adjusted EBITDA is a valuable and widely used financial metric that, when properly understood, can provide a more accurate picture of a company’s operational profitability. It helps investors and analysts normalize a company’s earnings by removing the distorting effects of one-time events and unique financial structures.

However, its non-standardized nature means it requires a careful, critical eye. By understanding the common adjustments and scrutinizing a company’s reasons for using them, you can move beyond the headline numbers and make more informed investment decisions. 

This metric is a powerful lens, but remember that a lens is only as good as the person looking through it. Don’t just accept a company’s story—use Adjusted EBITDA to build your own, more complete narrative of its financial reality.