Sunday, December 21, 2008

Enterprise Value and Free Cash Flow I

Once upon a time, we talked about a radical ratio called EV/EBITDA which was invented and nearly won the Nobel Prize in Most Innovative Financial Ratio ever invented. Well someone topped that and invented EV/FCF which is Enterprise Value over Free Cash Flow.

What's so great about EV and its alphapetical soup of acroynms? Ok, let's define the terms first.

EV = Market cap + Net Interest bearing debt
FCF = Cashflow from Operations - Capex

For the uninitiated, pls follow the hyperlinks and read what is Market Cap, Cashflow from Operations etc. I will explain EV and FCF.

EV stands for Elise Vuitton, cousin of Louis Vuitton who recently came out with her own luxury brand of leather bags to grab share from the legendary LV.

Oops, wrong number. Ok, here's the real deal.

EV is sort of the theoretical takeover price of a company. In the event of a buyout, an acquirer would need to pay the market price (or market cap) to the existing shareholders. However he would also have to take on the company's debt, but pocket its cash (hence looking at NET interest bearing debt is impt). If a company has no debt and some cash, then EV is less than market cap and the acquirer will be getting a bargain!

Actually in today's market, some co.s are trading below net cash! This means that EV is actually negative. You get paid to buyout some co.s listed on SGX! It goes to show how irrational things can get when markets go crazy. However, as quoted by the great Keynes: markets can stay crazy longer than you can stay liquid. Well usually also longer than you can stay patient lah. Nevertheless, having said all that, it goes to show that markets today are really cheap. This is the Great Singapore Clearance Sale value investors have been waiting for! But wait tomorrow things can get cheaper though.

Anyways, that's EV. In the next post, we shall explore Free Cash Flow or FCF.


  1. Dear 8percentpa,

    FCF = Cashflow from Operations - Capex. Would you consider "dividends received from associated companies or joint venture companies" as part of FCF? They are categorized as cash flow from investing activities and hence excluded from FCF. However, they are indeed free cash flow for the parent company, aren't they?

    For example, for SIA Egineering, dividends received from its associated companies and joint venture companies is about the same level as its operating cash flow. if these dividends are included in the FCF, FCF will be more than doubled.


  2. Hi Anonymous,

    There are no hard and fast rule shere. I would recommend the following:

    If the dividend payment had been stable for the past few yrs and are likely to be stable in the future, then I would include that in my calculation. To add to that, if you have any reason to believe that the dividends will be stable then it should be included.

    If not, then probably it should be excluded.

    For the case SIA Engineering, I took a look at their cashflow for the past few yrs but I couldn't find the big dividends that you talked about. Maybe we are looking at different time frames.

    Based on my limited knowledge, I would reckon that the dividends would not be stable, and would choose to ignore them.

    Hope this helps!

  3. Hi 8percentpa,

    Yes, I agree with you. It is the stability of dividends that matters.

    Let's come back to the case of SIA engineering. Comparing with its operating cash flow, the dividends that it received from associate companies or joint venture are significant enough to warrant consideration for last few years (2003-2007). I write down the figures from its anual reports as follows (in millions).

    CASH FLOW 2007 2006 2005 2004 2003 2002 2001 2000
    Cash flow before working capital changes 157.93 152.67 175.681 129.32 107.454 169.475 222.922 130.639
    Cash generated from operations 91.72 145.39 180.389 100.794 118.609 189.587 164.797 135.528
    Capital expenditure -58.50 -47.13 -39.604 -58.357 -25.53 -28.84 -47.183 -20.185
    Dividends received from associate companies 55.27 31.90 11.922 4.827 27.984 22.424 8.474 1.77
    Dividends received from joint venture companies 33.72 13.88 52.112 25.951 2.005 0 0 0
    FCF (exclusive of dividends) 33.21 98.25 140.79 42.44 93.08 160.75 117.61 115.34
    FCF (inclusive of dividends) 122.20 144.03 204.82 73.22 123.07 183.17 126.09 117.11

    Consider last 5-year average, the FCF exclusive dividend received is 81.55m, while the FCF inclusive dividend received is 133.47m---over 60% increase if dividends received by the parent company are included.

  4. Hi Anonymous,

    Yeah, I have to agree with you the dividends are significant, and would likely continue.

    The no.s I saw are from the financial information providers. I think they screwed up somewhere and hence the dividends are not as big.

    Your source is the annual reports. Nothing can be more authentic.

    The next qn to ask would be is it cheap enough? The EV for SIA Engineering is about S$1.8bn

    So EV/FCF = about 13.5x

    I would say that it's quite fairly valued or we can even argue that it's a bit cheap bcos it's FCF has never been negative and it's likely to continue to grow. Which will bring future EV/FCF down.

    Well it should be a better buy than SIA I guess :)

  5. Yes, EV/FCF = 13.5x is quite fairly valued. The market has quietly bid up good stocks like SIA Engineering, although the STI index were hovering around 1700.

    I am experimenting an strategy, that is waiting patiently and buying stocks only when they hit my conservative valuation. For example, my conservative valuation of SIA Engineering is 1.50, at which price the purchase should provide sufficient margin of safety. What do you have to say about such strategy?


  6. Hi Ryan,

    Your strategy is the classic Ben Graham value investing strategy. It will ensure capital protection. But you have to live with missing out a lot of happening stocks.

    Over the long run, according to Graham, you should get a decent return, say 8% per yr (my blog name) or so. Well that's all from textbooks. I am just parroting here.

    Since I have only invested for about 10 yrs, and half the time my knowledge base was slightly better than apes', I can't really say from real experience how it will be.

    Do hope it works, I am investing akin to that style too!