Today we wrap up the level II material on market-based valuations with Price-to-Cash Flow and Enterprise Value-to-EBITDA ratios. You will need both of these concepts different parts of level II and in the level III exam so make sure you know the concepts as well as the basic formulas.
Price-to-Cash Flow Ratios
There are several of these ratios listed in the curriculum but the most attention is given to Free Cash Flow-to-Equity (FCFE). You should already be familiar with FCFE and FCFF from the corporate finance material as well as in other parts of the equity curriculum. For the other P/Cash Flow ratios, just remember some of the adjustments that are typically made like non-cash charges and financing. Cash Flow metrics are preferred because it is not as easily manipulated by management as earnings numbers.
Free Cash Flow-to-Equity (FCFE)
The calculation for FCFE is fairly easy but you need to make sure not to get the components confused with FCFF. FCFE is CFO minus investments in fixed capital plus net borrowing, or the cash flow available to common equity holders without placing a burden on operations.
FCFE can be more volatile than other cash flow measures because of the capital expenditures spending, so you might have to use a multi-year average if the test question mentions it. Though you will probably not be asked to do so on the test, some analysts adjust CFA for nonrecurring expenses before calculating FCFE. A big focus in the CFA curriculum is conservative practices, almost always favored when a choice is given. Adjusting items for non-recurring events and taking the average of volatile accounts over a period of time are more conservative and provide a more stable estimate.
Make sure you can go from FCFF to FCFE or can get there from multiple routes. Thinking through the various accounts and why they are included will help get these concepts down. PRACTICE, PRACTICE, PRACTICE.
FCFF = CFO + interest(1-tax rate) – Fixed Capital Investment
FCFF = EBITDA(1-tax rate)+depreciation expense(tax rate) + (increase in deferred tax) – (investments in fixed and working capital)
FCFE = FCFF – interest(1-tax rate) + net borrowing
EV is the total value of firm in excess of cash and investments. This is the market value of debt plus common and preferred equity, minus cash and investments. We use the market value of debt because it is a more realistic amount that someone would pay for the firm, when combined with equity. Earnings before interest, depreciation and amortization (EBITDA) measures the potential cash flow to all providers of capital, so by taking a ratio of the two we find a market driven valuation of the firm.
The advantages of the metric are that it is more appropriate when valuing capital-intensive companies or those with differing amounts of leverage (because it is a pre-interest and depreciation measure). The metric is also useful when earnings are negative and P/E cannot be used.
The main disadvantage is that it does not account for several adjustments that should be made for good measures of operational cash flows. Different revenue recognition practices will change results as well as trends in working capital.
Generally, higher valuation multiples mean more expensive valuation. It may seem a little simplistic, but the curriculum spends a lot of time on these market-based valuation measures. Understand each one and its advantages & disadvantages. Given the multiples for two or more companies, be able to say which one is most overvalued and which one is most undervalued. Just remember, relative valuation (the fact that one asset is less-expensive than another based on a market multiple) does not necessarily mean that it is a good investment only that it is less expensive when compared to another investment.
All for today. Only seven weeks left, don’t forget to hit those practice problems.
Joseph Hogue, CFA