To review for just a second, last time I discussed differences between Equity Value and Enterprise Value. From now on, these values are going to be the numerator in the Value/Cash Flow quotient when we think of valuation in terms of cash flow multiples:

Value ÷ Cash Flow = Multiple of Cash Flow

To complete this thought though, I need to go into more depth about the denominator, cash flow, as I said I would earlier.  In real world corporate M&A, there are essentially four derivations of cash flow commonly discussed and used:

1. EBIT (Earnings Before Interest and Taxes): Most of the time EBIT is the same as Operating Income on the income statement (verify that interest and taxes are below the line). In some cases you may need to adjust for one-time charges (such as stock-based compensation).
2. EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization): This is the same as EBIT but with Depreciation/Amortization added back.
3. Unlevered FCF (Unlevered Free Cash Flow): UFCF is typically defined as Cash Flow from Operations minus Capital Expenditures (both from the Cash Flow Statement) plus Net Interest Expense (from the Income Statement).
4. Levered FCF (Levered Free Cash Flow): LFCF is typically defined as Cash Flow from Operations minus Capital Expenditures.

Why 4 different types? Because different cash flow types are appropriate for analyzing and valuing different types of businesses. It depends on the type of company you’re analyzing and how their business uses capital. For example:

• For companies heavily dependent on debt, like banks, airlines, or LBO’d companies with lots of debt, it makes most sense to analyze Levered Free Cash Flow because the cash flow then includes the consequences of the debt capital structure (allowing for apples to apples comparison with other similar companies). Conversely, Unlevered Free Cash Flow is more appropriate for comparisons, analyses, and valuations that are capital structure “neutral”.

• For companies with high CAPEX, like manufacturers, EBIT is usually the most appropriate cash flow type to analyze. EBIT includes Depreciation and Amortization and, over time, reflects the heavy fixed asset commitments these companies must typically make.

• For companies with large amounts of deferred revenues, such as subscription-based services, software, internet, cable, telecom, etc., Unlevered FCF is probably best (better than EBITDA). Unlevered FCF includes working capital changes from the Cash Flow Statement (including upfront cash payment often before revenue is booked) and capital expenditures, which can be large uses of cash for these types of companies.

Picking the most suitable cash flow gives the best insight into the subject company’s capital structure and business model, and allows for better comparison with industry peers and a more accurate analysis and valuation.

Got it?

Next time, I’m going to complete the quotient with these two concepts – value and cash flow — and discuss the implications for valuation.

Posted by: Mory Watkins