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Hello Folks:

Hmmmmm.....the EV/FCF ratio.

In the numerator, EV (enterprise value) represents a number that begins with market cap but then it excludes cash, certain investments, and debt. Essentially, EV is the market's valuation of the core net operating assets of the business enterprise (because certain financial items are removed). In the business world that I work in, for a variety of tax and legal reasons, small business acquisitions are often structured as asset sales rather than stock sales. As a practical matter, the seller will exclude cash from the transaction and the buyer will bring in new financing to the deal such that the existing debt of the business is paid off before the deal is closed. Therefore, if one were to start with a valuation of the equity (or negotiated price for the equity), adjustments would be made to exclude the cash and debt (cash would be subtracted from the equity value and debt will be added back to the equity value) to derive the purchase price of the net operating assets being sold.

Let us now move to the denominator, FCF (free cash flows). As many of you know, there are many variations of free cash flows being used out there. For those of you who are familiar with the teachings of the valuation guru, Dr. Aswath Damodaran, FCFE (free cash flows to equity) and FCFF (free cash flows to the firm) are often discussed. So what should be the definition of free cash flows with respect to the EV/FCF ratio?

Since cash, certain investments, and debt are being removed in the numerator, in my humble opinion (which to some folks appears to be somewhat twisted), investment income (relating to interest bearing cash accounts, cash equivalents and certain investments), and interest expense (relating to debt) should be excluded from the free cash flows number. Therefore, as a practical matter, one might find it useful to begin with NOPAT (net operating profit after taxes). Yes, depreciation and amortization would be added back to NOPAT and capital expenditures would be subtracted. In addition, there are some changes in working capital items that should be added or subtracted as well.

Matt's article included deferred income in his definition of free cash flows. On the balance sheet of some companies (such as Microsoft), you will find a classification of deferred income in the liabilities section. This number represents “prepaid income” whereby the customer either paid or was billed for goods or services that have not yet been earned by the company (otherwise such amounts would be part of net revenues on the statement of income and included in NOPAT). The net change in the deferred income amount (difference between the amount reflected on the beginning balance sheet versus the amount reflected on the ending balance sheet for the accounting period) would be one of the working capital changes to consider. Other material working capital items to consider as well include accounts receivable, inventories, and accounts payable. Accrued interest expense (liability classification) is a working capital item as well but this would not be considered because it relates to interest expense and debt. Unfortunately, on 10-K and 10-Q filings, accrued interest expense is more often than not bundled together in a category that might be called “accrued liabilities.” In such a case, it is easiest to just assume that the change in accrued interest component is not material and take the change in accrued liabilities into consideration for the free cash flows number.

If there are certain nonrecurring (one-time) items included within NOPAT, the net after tax amount of such items should be removed.

Just as the good Admiral mentioned in the newsletter, the free cash flows number can vary substantially from one period to another...particularly for companies that experience substantial changes in capex and working capital components. In such a case, you might consider using an average of several past years.


Best regards,

LeBean :-)
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