It's the start of the fourth quarter, and investors are gearing up to look toward quarterly earnings reports to find out if they should invest (or stay invested) in certain public companies. One metric you'll find in the report is EBITDA (earnings before interest, taxes, depreciation, and amortization).
EBITDA isn't like other metrics. One aspect that differs is its regulation—or lack thereof.
EBITDA isn't regulated like other earnings metrics
To find out a stock's book value, you need to determine different profitability metrics. Many of those—like operating income, earnings per share, and revenue—are regulated under GAAP (generally accepted accounting principles).
However, EBITDA is considered a non-GAAP financial measurement. As a result, it isn't regulated like other metrics.
Why EBITDA is a non-GAAP financial metric
Companies often put out an adjusted EBITDA. A company can adjust the EBITDA in any way it sees fit. For example, it might eliminate large, ad-hoc expenses from the measurement in order to appear more profitable. These one-time expenses could include equity compensation for executives, litigation costs, investment losses, and more.
These are all big factors that can eat into a company's profitability, which is why it could be in the company's best interest to remove them from the EBITDA equation.
A company defines exclusions for its adjusted EBITDA within the document, but it isn't right on the income statement and can be difficult to find. Some companies even have extensive exclusions that really doctor the EBITDA.
Why do companies focus on EBITDA?
Some companies don't have profitability on their side. For example, companies in clinical research, engineering R&D, or another phase that's light on revenue might not want to boast about their GAAP metrics for a particular quarter. That's where the EBITDA comes in handy.
In many cases, EBITDA can help investors gauge how a company is really performing. If GAAP metrics don't capture the full picture due to uncommon or one-time expenses, EBITDA fills the gap.
Why you shouldn't rely on EBITDA alone for investments
Before determining whether you can trust a company's adjusted EBITDA, read its complete list of exclusions. What's the extent of the expenses and should you worry about them in the future? A long list of exclusions could indicate that a company is trying to distract people from subpar finances that might indicate a risky investment.
Just look at Uber Technologies (NYSE:UBER). Its annual report for 2020 laid out a lengthy list of exclusions that made the adjusted EBITDA a lot different from the profitability measurements.
Some companies don't even provide an EBITDA since it isn't a legally required metric, although it can be deduced from regulated profitability measurements.
Whatever the case, take EBITDA with a grain of salt, and consider eliminating adjusted EBITDA from your analysis. It's a metric that can skew a company's finances in a positive direction. Public companies will bite at the opportunity to market themselves in a positive light. In some cases, EBITDA is a completely valid measurement. However, it all depends on the context. Read the company's exclusions, compare it with GAAP metrics, and make an educated choice on whether to buy, sell, or hold.