Saturday, December 27, 2008

Enterprise Value and Free Cash Flow II

This is a continuation of the last post talking about EV and FCF.

A company generates cashflow based on its day-to-day operations. Eg. SIA selling air tickets with fuel surcharges 2x actual ticket prices. The millions of ticket sales generate cash. Of course SIA needs to pay the pilots, the stewardesses, the fuel, landing charges etc. After netting the expenses, it should still have cash left. Some co.s don't, if you own some of these, good luck! Anyways, this no. is called Cashflow from Operations.

Next, SIA needs to spend some of this cashflow on equipment to maintain its operations. Like buying new planes, pilot training programs, etc. This no. is called Capex which is the short-form for capital expenditure.

When you deduct Capex from Cashflow from Operations, you get a no. called the Free Cash Flow. Basically, that's what's left that can be distributed to shareholders or to pay down debt. If the company has no debt, it's basically money that can be paid to the shareholders.

Over the course of many many years (like 10 yrs or more), a good co. will generate significant Free Cash Flow and has the capacity to even grow this amt over time. Now finally, things are getting interesting right? These are co.s that value investors look out for. Usually, I would look at that past 10-15yrs of FCF and take an average amt to use that to calculate EV/FCF. I am assuming that the company can generate this average FCF in the future for many many years.

Let's look at SIA. Over the past 10 years, SIA has 5 yrs of positive FCF and 5 yrs of negative FCF. Cumulatively, it generated a miserable S$175mn of FCF. Our ministers' salaries over 10 years would have generated as much. This is what the most profitable airline in the world can manage. Moral of the story: Don't ever buy an airline!

Combining the two things, you get EV/FCF which is just a measure of the cheapness of the company. The lower the better, like the PE ratio. If this ratio gives 5x, it means that theoretically, you get back your money in 5 yrs. Usually it doesn't get cheaper than that. EV/FCF ranges from 5-15x usually.

Again, back to SIA, the EV is S$8.8bn based on current stock price of S$11+. Calculating EV/FCF give 8800/175 = 50.3x. If you buy SIA today, the free cashflow generated should be able to cover your purchase in about 50 yrs. That's great isn't it? Maybe just in time to cash out and pay for the funeral expenses!


  1. LOL! You're a really funny guy. I literally laughed out loud when i saw that last 2 sentences!
    Actually, where do you look to find all those ratios quickly?

  2. Just curious, isn't total FCF going to approach total net profit over a time frame of 50 years?

  3. Hi Ricky, just trying to post humourously, I am quite serious in real life. :)

    Hi Cif, you did bring up a good point. I thought about it for quite some time, and here is my explanation.

    Acoording to textbooks, FCF will not converge with Net Profit. Net Profit goes to Shareholders' Equity. FCF goes through other adjustment from Investing Cashflow and Financing Cashflow and becomes next yr's cash balance.

    My guess is FCF will roughly equate to Net Profit if
    1) Co's capex and depreciation evens out over time
    2) Co. has v. little or no debt

    In case of 1. Some co capex will always be greater than depreciation: like SIA, semiconductor etc. Some really good value co.s will have capex much lesser than depreciation - these are what we want.

    Although in most cases, a normal co. should have capex = depreciation.

    For 2, since most financing cashflow deals with debt, if this is out of the way, we can assume that they should converge.

    I am not an expert in accounting, just know enough to scrape by. The above would be my own explanation about how to think about FCF and Net Profit. Hope this helps!

  4. My thought is that if you own a company long enough (e.g. 50years), the total cash that can be extracted (FCF) will come very close to the total net profit less the adjustment to the balance sheet.

  5. it's me again.

    If the capex is consistently above depreciation, the balance sheet will grow. If revenue doesn't correlate to the additional capex, profit and FCF will go down, hand in hand.

    Debt should affect the balance sheet. Not to say they don't affect net profit or cash flow, but because the interest will be accounted on BOTH statements and therefore cancel each other. Meaning, over the long run, debt affects the net profit and FCF equally. It will be clearer if the starting debt amount and ending debt amount are the same. The difference will again be a balance sheet item.

    So my point is that total FCF will approach total net profit over time, if we account the Capex and Debt in the balance sheet accordingly.

  6. Hi Cif

    I think we agree on this point: total FCF will approach total net profit over time, if we account the Capex and Debt in the balance sheet accordingly.

    I am unsure as to whether they should be equal in the strict accounting sense. My guess is that they shouldn't.

  7. Yeah, agree.

    That leads to my viewpoint that using PE or FCF as valuation essentially yield the same thing.

    The important part though is to use "adjusted" PE, because PE and FCF can differ quite significantly on yearly accounts. I am sure that in some years, the FCF of SIA exceeded E.

    Having said that, SIA model will have to continue to "throw money in" to the balance sheet to maintain its profitability. And as investor, I am sure we want a business that "throw money out".

    Therefore, simply determine the PE and think about the business model. Is it a TMI or TMO one?

    I think I talk too much.

    Cheers and Happy 2009.

  8. Hey! Cif, great point, think about it more and elaborate and maybe post your findings for us :)

  9. Hi Cif and all,

    A Happy 2009! Hopefully this yr the market will be healthier!

    I do agree that different valuation matrices should give the same conclusion if a firm is sound, accounting properly done, and mgmt integrity is intact etc.

    I myself use the PE more than any other valuation matrix when first looking at a stock as it is easily computable and convenient.

    I think FCF provide insights into capex needs of a firm and help us determine whether the firm is TMI or TMO in a quantitative sense.

    Nonetheless, it is not perfect, as with any other matrics. It's never 100% straightforward. That's investing and that's part of the game.