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FCF/P vs. FCF/EV


frommi
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I am recently scratching my head about that topic. So given two investments one where marketcap=EV and one where marketcap=1/3 EV and both trade at the same FCF/P. Which one do you prefer? (Under the assumptions that growth rates and FCF stability are the same)

 

At first glance i would have answered the investment without debt because that trades at a higher FCF/EV. But the one with more debt probably has the higher upside or not? And when i compare that way, should i add back interest expenses to FCF?

 

Capital allocation for the CEO of the indebted company is probably easier because all they have to do is pay down debt to get a higher FCF/EV, whereas the CEO of the company without debt has to make intelligent buyback decisions.

 

Which one do you prefer?

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If you were buying the entire company which would you prefer?

 

 

I definitely prefer the one without debt.  You eventually have to pay back the debt - and this is usually in less than ten years so it really matters for valuation purposes.

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At first glance i would have answered the investment without debt because that trades at a higher FCF/EV. But the one with more debt probably has the higher upside or not? And when i compare that way, should i add back interest expenses to FCF?

 

How exactly are you calculating FCF? I typically resort to FCF to the firm, where interest expenses are not subtracted (just adjusted for tax shield). One should compare FCF-firm to EV.

 

If you want to do FCF to Equity you adjust the FCF for interest expenses paid and net borrowing, to get an idea of how much cash is available for the equity holders. FCF-equity should be compared to your P.

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I will generally use pre-interest cash flows to EV and deduct interest when using market cap.  But it is hard to compare values of levered to unlevered companies for this reason.  I usually look at EV/EBITDA, EV/EBIT and P/FCF and try to find something that works on all the metrics.  If one of those numbers is an outlier that's telling you something, whether it's something in the capital structure or reinvestment needs.

 

I think the balance sheet risks need to be assessed separately from value.  Leverage works both ways.  So do you care more about upside or downside?  There's nothing wrong with some leverage if the cash flows are fairly secure, but that might be a lot of leverage.  If the stock is trading at book then debt is 2x equity, more if P/B is higher.  Is there a margin of safety?

 

As far as capital allocation, I think debt handicaps them.  Aside from any covenants restricting dividends or buybacks, they will have fewer options to take advantage of low rates to pay buyback stock, do an acquisition or reinvest in the business.  If you don't trust management to make intelligent decisions then it's probably a pass anyway.

 

But if you like the levered business, I would focus on position sizing.  I look at potential downside in sizing positions.

 

 

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If you were buying the entire company which would you prefer?

I definitely prefer the one without debt.  You eventually have to pay back the debt - and this is usually in less than ten years so it really matters for valuation purposes.

 

I shouldn`t overthink the things, you are of course right. So in the end FCF/EV is the metric that should matter.

Now i really don`t understand why people think AIQ or Intralot are super cheap, because on that metric AIQ has barely an 8% yield?

H&R Block or Verisign for example trade at the same FCF/EV yield, but are surely better businesses?

Or am i doing something wrong?

 

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Is the assumption of FCF that depreciation rate for financial reporting equals replacement capex for the same period? Any mismatch would seem to suggest some adjustments are in order.

 

Is the assumption of FCF that depreciation rate for financial reporting equals replacement capex for the same period? Any mismatch would seem to suggest some adjustments are in order.

 

In the case of AIQ i took 66 million $ as FCF and 766 million $ as EV. They are not growing so its reasonable to assume that reported capex equals maintenance capex or not?

 

Intralot looks to be cheaper, but a lot riskier. I calculated with 80 million € FCF and 630 million € EV. Ok thats a 12.7% yield. But thats still nothing that cries buy me into my face. Even at a marketcap of 0 € it is just a lottery ticket with a 15% FCF yield and no downside protection. When i look at my japanese stocks there are things that look cheap on every metric you use on them and trade on FCF/EV yields of 40-300%. And at the same time they trade below liquidation value.

 

But i am sure i am missing something, because Packer is successfull with this kind of investing, but what is it?

Packer i need your help :).

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For what it's worth, I've done this analysis on several stocks I'm interested in, of varying business quality from average to great and the yield as you have mentioned for most of them is around 10-12%. This is despite some of them having internal rates of return of 16-20%+ and others having roughly 10-12%. Obviously one would prefer the quality business with the high internal return even if it returned the same as the "junkier" businesses. But still, 10-12% is not anything that cries out to be bought.

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The answer is if they both have the same type of governance and industry conditions the one with no debt as it is earning more on its capital so it should be worth more.  If the industry is one with competitors with debt, the debt-free company can take on debt and pay out a dividend.  For something like this to happen though you need to understand managements motivations.  Is to keep the company debt-free to keep there jobs or to maximize shareholder value.

 

For AIQ, I think they have a manageable amount of debt and are controlled by a capital allocator I admire Howard Marks.  If Marks was not in the deal it would not be as interesting.  I also know that transactions happen in the industry at 7x EBITDA and the comps are trading at a premium to 7x.  So I have alot of independent benchmarks of value I feel I understand.

 

For Intralot, it selling for less than half of already cheap competitors and is in a consolidating industry.  Management is not top notch but the business is a good business and given the dynamics of the industry they may be bought out.  The funny thing is they move up and down with Greek stocks but less than 5% of there business is in Greece.

 

Given current pricing, you have pick the kind of rick you can tolerate and understand.  You can get great prices at times of panic but those do not happen often so you have to find what types of risk you feel comfortable with when these are not available.  At this point I don't understand much about the risk of Japanese stocks so I have not done much there but I am starting to learn.  Heck, I even bought the Japanese Company Handbook.

 

Packer

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I think industry is very important as Warren Buffet has said an industry's economics will win over a management teams efforts in most cases.  Some of my best investments have been in second or lower place companies in good industries that is part of the rationale for Intralot.

 

Packer

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