This week on Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Tim Beyers answer a listener question: What's the point of EBITDA? Why does anyone care about it? Why do companies report it, and why do analysts track it? The hosts break down the metric for listeners who might not be familiar with it, then explain how it gets used for good and for bad by more and more high-flying companies every quarter. Tune in to learn the EBITDA red flags, when this non-GAAP metric might tell you something meaningful, the EBITDA difference between Amazon (NASDAQ: AMZN) and Snap (NYSE: SNAP), what this whole "adjusted EBITDA" thing is all about, and more.

A full transcript follows the video.

This video was recorded on April 5, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 5, and we're talking about a big non-GAAP metric. I'm your host, Dylan Lewis, and I've got Motley Fool premium analyst Tim Beyers on Skype. Tim, what's going on? 

Tim Beyers: How are you doing, Dylan? 

Lewis: I'm doing alright! It's nice to chat with you! You are over in our Colorado office. For anyone that winds up watching the video of this, you have a very nice scenic Colorado-esque backdrop behind you. 

Beyers: [laughs] Yeah, we're in the Flatirons Conference Room. We put up some murals to celebrate the mountains around us. This one is the Flatirons conference room in in Boulder, so you're seeing a picture of Boulder behind me even though I'm not actually in Boulder. 

Lewis: I was going to say, I've seen pictures out the window of the Colorado office that we have, and it looks an awful lot like that. You could have had me fooled there. Well, I'm happy to have you on! We haven't actually done a show together to my knowledge. In the time that you've been out in Colorado, I'm just happy to have an excuse to chat with you, Tim.

Beyers: Yeah, same here, man! We've known each other over the years, because I was writing for fool.com for so many years. This is the first time we've ever done something like this. [unclear 1:24] ... about companies that have either exploited or abused this topic that we're going to get into. 

Lewis: That's absolutely true! The reason that you're on today is, we got a listener question. I put it out to the folks that are aware and involved with our podcasts, and said, "Hey, does anybody want to tackle this?" You shot up immediately and said, "Yes, I want in!"

I'm going to read that question and then we'll start digging into why you are so excited to talk about It. This is a note we got back in January from a listener. PT wrote into the show and asked: "Hi, Motley Fool family. I have a general finance question that's been bugging me for years and I'm finally asking. Why does anyone care about EBITDA? I know what it is. I know it stands for earnings before interest, taxes, depreciation and amortization. What I've always struggled with is why anybody cares. Don't I want EAITDA -- earnings after interest, taxes, etc.? Why tell me how much you made before your bills came due and assets lost value? Honestly, it makes no sense to me. My dad tried to explain it, saying it's useful for creditors to determine if they have the cash flow to cover payments. I get that, but still only to a point. If I was a creditor, I'd probably like to see EAITDA. If I'm an equity holder, what good does EBITDA do me at all?"

What a question, Tim!

Beyers: Yeah, I know. It's amazing! It's a good question! Because EBITDA is one of those mysterious non-GAAP metrics. When we say non-GAAP, we mean, most companies have to report their financial statements according to what are called generally accepted accounting principles, that's GAAP. When you have a non-GAAP metric, it means it's not something that the regulators require, but it is something that a company wants you to look at because they think it's useful for measuring their business. EBITDA is generally useful for measuring a company on an equal basis. Dylan, you had something to say about this. If one company has a lot of debt and other company has a lot of equity, you want to be able to measure those two companies side by side, especially if they're in the same industry. 

Lewis: Yeah, I think it's most helpful if you're trying to control for financing structure. That's one of the easy ways to look at it. You take two businesses, and almost every other line item is the same in terms of revenue, cost of goods sold, all that kind of stuff. You have one business that is entirely equity-financed, another business that is entirely debt-financed. Well, the one that has debt financing is going to have interest payments, so it will show a little bit less net income than the other company. Of course, if you look on an EBITDA basis, because you're adding that back in, you wind up with two businesses that have the exact same EBITDA.

Beyers: Right. EBITDA is also very useful for looking at companies that are in an investment phase. There are a lot of tech companies -- I know you talk about a lot of tech companies on this podcast, Dylan -- that start in a heavy investment phase. At that point, there is something to be said for adding back the depreciation on those assets. Over time, those assets are supposed to be income-producing. Now, you can abuse that, of course. But there are instances where EBITDA tells you a lot about a company that's in the investment phase. 

One that we were talking about before we came on the air was Amazon. Amazon created Amazon Web Services in 2006. If you were to look at the income statement and earnings between 2006 and current, it wasn't until only recently, the last couple of years, where those earnings weren't bouncing around all over the place and running negative in some years. If you looked at the EBITDA, it was a little different. The reason for that is because Amazon was investing in infrastructure that was paying capital back to the company over time. They were investing in warehouses, they were investing in servers, they were investing in software that they could use to sell more of Amazon Web Services. So, by accounting for the value of those assets that they were investing in and depreciating over time, you got a better picture for the real cash earnings of this business. Turns out, if you look at Amazon, boy, there are few cash earners like this one. 

Lewis: Yeah. If you truly have an asset that is going to be producing a lot of cash for a company, EBITDA is a very useful metric to be looking at. It's one of those beautiful metrics because you can calculate it by following the name. It is the earnings before interest, taxes, depreciation and amortization. If you're trying to calculate it, net income plus all those expenses. Alternatively, you could look at your operating profit, add depreciation and amortization in, and basically have the same number. 

Beyers: Right. It may be worthwhile just for a second to talk about what depreciation and amortization are, without getting too much into accounting speak. Basically, if you buy an asset -- you buy a computer, let's say, and that's something that's supposed to help you produce income as a business. We're in the publishing business here at The Motley Fool, so we buy computers. Computers do help us make money. So we depreciate the value of those computers over time. So you determine the useful life of that. Then, on a schedule every year, you depreciate some of that. That comes off of your income statement. It's an expense. But then, on the cash flow statement, it gets added back in because there was no cash spent, the cash was spent earlier. Now, you're getting a credit back after you spent it. It's accounting, so it's a little wacky, but that's the reason for it. You are accounting for the useful life of something that's making your business money over time. 

Amortization is pretty similar. You amortize things that have a useful life, but they have a value. An asset has a value over the course of time, so you pay for that asset over the course of time, and then you write down the value of that in an amortization schedule. 

It's a little funky. Basically, what it means is that businesses invest in things. Those things have a value. You don't recognize the value of that all at once, because if you did, you'd be saying, "This thing I bought is going to bring me value. Here's the value it's going to bring me. I'm going to claim it all right now." That would be really weird. Accounting normalizes for that.

Lewis: Right. That's where we get the smoothness with a company like Amazon with its AWS investments over time, looking at the EBITDA metric, not so much looking at the traditional income statement. I think of metrics generally like a tool, Tim, both for companies and for analysts. Like almost any tool, it's something that can be used positively and it's something that can be used negatively. I think if you're looking for good, positive uses of EBITDA, it is for just that. You have an asset that is going to be producing cash for a long time for a business, and you just want to get a sense of what it looks like in a little bit more stable terms. 

Beyers: Right. For our listeners, who may be in Premium services and they've seen us recommend businesses like Amazon or Equinix, which is a data center provider, or American Tower, which is a very popular one among Fools, these are companies that have hard assets, they've made big investments, and those investments produce cash over time. There are other ways to abuse it. Depreciation and amortization really are accounting for things that are "noncash charges." If you're watching the video, you'll see me do the air quotes. If you're listening, I just did air quotes. The idea here is that any noncash charge can show up and influence EBITDA. That can be things like stock-based compensation, or it could be the intangible value of an asset that was acquired. Let's say you're a tech company that is trying to roll up an industry in healthcare, or something like that. You buy a bunch of different companies. In those companies, there are products in development, but they haven't been released yet. Well, those products have intangible value because they haven't been released. You can say, "This has $5 million in intangible value." That influences your EBITDA. So, you can really game the system by using EBITDA. 

What you really want to look at, the real question to ask, is why. Why is EBITDA an important metric for this business? If it's primarily because they're investing in big assets that are tangible, that you can see producing income over time, then that's probably a good use of the metric. If it's very funny, if there's a lot of stock-based compensation, or there's a lot of intangible assets that are being amortized that influence that, watch out! That's probably a warning sign. 

Lewis: Yeah, that's when I start to go on high alert. I think the reason EBITDA does get a bad rep among some analysts is the fact that it is a very easy thing for companies to point to if they are desperately trying to hide bad results, right? If they're losing a ton of money, but they're like, "Hey, look, on an EBITDA basis, we're positive!" That's where I think a lot of people, especially people in the tech space, start to look at EBITA with a little bit of scorn. 

Beyers: Right. There's something that's cropped up among venture capitalists and private equity investors in the tech space. This applies to this flood of IPOs that we have coming called the rule of 40, because EBITDA is such a popular metric because these companies coming out are losing money. The idea is the rate of revenue growth should be at least 40 points higher than the operating loss that the company is reporting. Let's say they're growing at 120%, but their operating margin is negative 40%. That's plus 80%. That means you can reasonably assume, over the course of time, that growth is going to bring them into positive territory. If it's negative, then even if they come out the gate saying, "Look, we're positive on an EBITDA basis!" look out!

You really do want to look at where the why is. Lyft is a good example. Just came public. Very interesting company, has a good brand. It's like the anti-Uber. But it's deeply unprofitable. If you looked at it on an EBITDA basis, it would still be unprofitable. But it's going to look better on an EBITDA basis because of its investments, particularly because of its investments in intangibles, its brand. It will say, "Our brand is one of our competitive advantages." You really want to be careful there, especially with a company like this. And I would bet dollars to doughnuts, Dylan, that Uber is going to say the exact same thing coming out the gate. It really is something to be cautious of.

What you really want to look for is higher gross margin and improvements in things like growing unearned revenue, things that are really cash-based, that show cash coming through the door. Lyft is a little funny in this area. It is important to keep a close eye on this. 

Lewis: Yeah. I think that this is something that is going to be a very big part of the conversation broadly in tech in 2019. You mentioned Uber. Also Airbnb, Slack. There are a lot of businesses that are probably not profitable yet that are going to be going public in this wave that we're seeing of unicorns hitting the public markets. EBITDA is going to be a number that gets thrown out there quite a bit. That's just because you see it more with your less established companies. It's a little bit easier to focus on that. 

We talked about some red flags before, Tim. One that I'd throw out there, too, is if you see a business that is leaning more on GAAP metrics, focusing more on their net income, and then all of a sudden focusing on EBITDA. That's a cause for concern. 

Beyers: Yes. And there's an easy way to check that. If you're an investor and you see this, what caused the shift? Is it a big investment in a tangible asset for a product or a program that you already knew was coming? If so, this is not news, it's just the accounting version of this news. That is less of a warning sign. If it comes completely out of the blue, like you're saying, Dylan, then that's a real cause for concern. It may be that they're trying to obscure parts of the operation that aren't performing well. 

Lewis: Yeah, absolutely! I think you just always need to know the why. The metrics are helpful. You always need to know the why. 

The other thing I'll throw out there specifically with EBITDA is, as non-GAAP metrics go, I think it is one of the more uniform ones. Apples to apples, if you just see EBITDA, chances are it's going to be fairly comparable across businesses as they're reported. That's not true for adjusted EBITDA. There are a lot of puts and takes that go into that number. And increasingly, we're seeing more and more of that metric in the tech space. 

Beyers: Right. And that's because companies want you to look at their results the way that they see them. That's not what you should be doing. As an investor, what you should be doing is looking at the value drivers. What really drives value here? It may be that EBITDA, like in the case of Amazon, tells you a lot about what's driving value in the company. I don't think any of us would argue today that Amazon Web Services or the logistics business that Amazon is moving into are not creating value for the company. Those started years ago, and EBITDA was telling us how they were investing. That's what you really want to know. 

Adjusted EBITDA is, "Here's EBITDA, and here are things we want you to ignore. Take our word for it." That's very, very dangerous. You really want something that is standard. Cash flow from operations, free cash flow, these are both non-GAAP metrics, but they are generally agreed upon. Free cash flow is not a GAAP metric, but it is something that's standard. EBITDA is, too. Once you start getting into, "Here's the thing we adjusted for. Oh, by the way, here's the five other things we want you to adjust for," you start playing a game of financial chicken, and things can get ugly. 

Lewis: Yeah. You've already removed quite a bit when you're looking at EBITDA. Adjusted EBITDA, especially for a lot of early stage tech companies, removes even more line items. The one that I think of most is stock-based compensation, a noncash charge and a lot of ways but one that I think investors need to be very aware of. I think of Snap in particular with this. They recognized a ton of stock-based compensation related to a grant that Evan Spiegel received. On an adjusted EBITDA basis, that got backed out. But, of course, that's a cost that shareholders really actually wind up carrying the burden for, because that's how stock-based compensation works. 

Beyers: Yeah. I think one of the best ways to think about stock-based compensation, especially among tech companies, there used to be a movement that says you just strip it all out. But I don't think that's right. What you want to do is, maybe take half of it, take a quarter of it, some portion of it. Whatever you choose to take a portion of, just think of it as, this is a company that's investing in its employees. Even though there's a noncash value to it, it's an investment. If it's an investment, it does have a cost, so it should show up on the income statement. Maybe the hit shouldn't be as big as it is, and you back some of it out, and you put some of it back on the cash flow statement, but you probably want to moderate it some. A good way to look at that is, maybe take a look at the industry this company participates in. How does everybody else do it? Do they tend to overvalue stock-based compensation? If you're dealing with an outlier, that tells you a lot. 

Lewis: Absolutely! The way to dig into that is to look and see what those reconciliations look like. Any company that's giving you an adjusted number like this is going to have to show you how they got to that number. So, you will get a nice breakdown of all of the puts and takes that go into that nice, shiny, profitable adjusted EBITDA number that they're highlighting in their earnings report. You can find that in their presentation, you can find that in the press release they put out. 

Beyers: Right. In the case of stock-based compensation, it's not hard to find out how they break that down. Sometimes they'll do it in a press release. At the bottom of the press release, it will say, "Here is the stock-based compensation that relates to R&D. Here's what relates to sales and marketing. Here's what relates to cost of goods sold," and so forth. If you see an outsized number that's in sales and marketing, and that feels funny to you, chances are, it's funny. 

Lewis: Yeah, yeah. So, for our listener, PT, that wrote in that's the rundown on EBITDA. I think even if you listen to all this, PT or any of our other listeners, and say "This metric still doesn't really make a lot of sense to me. I'd still rather be looking at all the GAAP metrics," you're in pretty good company. Right, Tim? There are a lot of the very well-known investors that say, "I don't need EBITDA, I don't need to be focusing on this."

Beyers: Right, and you don't. You can get lots of really great insight, just looking at the straight GAAP numbers and each of the three primary financial statements. Cash flow will tell you how much cash is coming out of the business. If it's bigger than net income, that tells you a lot. Really, what you want to pay attention to more than anything else, if all you do and nothing else, is find out, is the company growing? Is it growing faster than it did before? Is the gross margin rising? And are they throwing off cash as a result? If you can answer those three questions positively, you're going to be in really good shape.

Lewis: Yeah. Anything else before I let you go, Tim? I'm so glad that I was able to have you hop on and talk to me about it!

Beyers: No, this was great! I would say the primary thing is, these IPOs that are coming, they're all really, really interesting! Just be careful to not take management exactly at their word. Take it with a grain of salt. Don't be an uber-skeptic -- not literally an Uber skeptic, but, a super skeptic. Take a look for yourself. Chances are, if something looks funny, it is. You want to look further. Trust your instincts!

Lewis: Love it! Thanks for hopping on today's show! I'm hoping I can have you on again sometime in the future. Maybe we'll get you in a different conference room. I know you have red rocks over there as well in the Colorado office. We can change the scenery behind you. 

Beyers: Nice! Yes, we will absolutely do that!

Lewis: Thanks a lot, Tim!

Beyers: Thank you!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch the videos from this podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Tim Beyers, I'm Dylan Lewis. Thanks for listening and Fool on!