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When and how to use EV?


yadayada
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Let's say that a 15x multiple is reasonable for a business that is likely to grow with a moat and reasonable return on capital.

 

One business (that fullfills the above requirements) makes 100 million and has zero debt, the other company is identical in everything but has 1 billion in debt at reasonable interest rates. How much lower will the second company rate? If we say the first one deserves a 15x multiple, would the second one get a 10x multiple? If you go by FCF/EV first one deserves a 15x multiple? But the second one should by that same logic get a 5 earnings multiple vs a 15 earnings multiple? (to get the same FCF/EV ratio).

 

Let's assume that this business will v likely be around at least a bigger size then now in 20-30 years from now and like I said, they have a nice moat and arent a threat to each other.

 

 

Another example would be cigar butts Obviously if the business might not be around 10 years from now, debt plays a much bigger role?

 

What is a good way to think about this?

 

Real life examples might for example be Outerwall which has v nice FCF now (300 million), 600 million in debt, but might not be around in 10 years (or they might, you don't know). But it is certainly not a close to 100% probability they will in this size.

 

But for example GNCMA will v likely be around 30 years from now (and earn more) and has 100m in FCF and 1 billion in debt. So how much do you discount their debt in the FCF multiple here?

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You should always use EV when you compare businesses that have a different capital structure.

 

FCF/EV is not a suitable ratio because (usually) interest expenses are not excluded from the FCF number. You also need a predebt number for this (such as EBIT(DA) or FCFF).

 

If it's a business that will be around 30 years from now even with a 1 billion in debt the company with no debt would have a suboptimal capital structure and it would need to trade at a discount to reflect that fact. What the optimal debt load is depends on how much (business) risk the company has. A company with an above average amount of risk could trade at a market multiple if it has zero debt. A company with a low amount of risk could trade at a market multiple while employing a lot of financial leverage. It's all about risk.

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