Wednesday, October 12, 2005


For anyone who doesn't understand what the heck the title of this blog entry means... you're not alone! Heck, I myself don't quite understand it fully either, but I'm going to try to explain anyway :) My latest idea deeply involves the conceptual knowledge that goes behind these two ratios--it'll be the first time I actually try to explain MC/FCFE and EV/FCFF what they mean to me. So here goes!


I suppose the easiest way to start is with a question: What happens when a firm is loaded up the wazoo on debt, but still manage to make cash quarter-over-quarter and year-over-year? How do you measure the firm's profitability in terms of how much profit it can generate for equity holders and both debt AND equity holders? Well, my friends, you've guessed it... that's why MC/FCFE and EV/FCFF exists. They are seperate ratios measuring different returns different kind of investors look at when they value a firm. One is from an equity perspective, and one is from a debt perspective. Now, let me go over some quick definitions:

MC/FCFE is an abbreviation for the ratio between a company's Market Capitalization Rate (MC) and its Free Cash Flow to Equity (FCFE). Now, market capitalization rate I'm sure you all are familiar with, but what is Free Cash Flow to Equity you ask? Well grasshopper, the general equation to figure out FCFE is "Operating Income + Depreciation + Amortization - Capital Expenditures - Net Change in Working Capital - Interest Expense - Tax Expense" and sometimes it has R&D, Operating leases, debt issuance/payments that we don't need to worry about too much for the sake of simplicity.

EV/FCFE is an abbreviation for the ratio between a company's Enterprise Value (EV) and its Free Cash Flow to FIRM (FCFF). The enterprise value of a company can be calculated quite simply: "Market Capitalization + Net Debt" (Net Debt = Long/Short-term Debt Issuances - Cash). What does EV mean in abstract? Well, let's pretend that there's a company, and all that exists in this company is a I.O.U. note for $50mm and a bag of gold bricks worth $20mm. The market is currently trading this company at $30mm because the company is expected to magically make some income over the next couple of years. In a simple Market Capitalization scenario, we would put the company's value at what is stated: $30mm. In an Enterprise Value scenario, we also like to take into account the I.O.U. note and the brick of gold, which nets out to be $10mm in debt. So when you buy this company, what are you REALLY paying? $30mm? or $40mm? I'll let you smarties figure that out :D -- Free Cash Flow to Firm is exactly like Free Cash Flow to Equity, except you put back in what you've subtracted as interest expense.


So what are the implications of these two distinctions? Well for starters, MC/FCFE measures the profitability to SHAREHOLDERS the best, while EV/FCFF measures the profitability of the ENTIRE BUSINESS (shareholders and debt-holders). So how do we know which one to use when we're valuing a business?

The key point in the answer to that question lies in whichever fits the company's current state of operations the best. I've generally followed three guidelines when comparing the relative importance of the two ratios on a company.

1.) If the company is a cash monster and has no debt, then use EV/FCFF because its basically the same as MC/FCFE except your getting "cash back" with the EV adjustment

2.) If a company is highly levered, then use MC/FCFE because interest payments and debt is financial leverage that could be paid down over time, reducing expenses incurred by shareholders. If a company has $100mm in debt, and pays $10mm in interest expense every year. But that company is able generate $20mm a year, and use the remaining $10mm to pay the $100mm debt down gradually, then it will 1.) have less interest rate at the end of every quarter compounded to pay 2.) have more money left over to pay the principal. Lower debt + lower interest = higher value for shareholders.

3.) If a company's debt and cash balances are quite similar, then value both ratios equally. Chances are, they will come down to a pretty similar ratio figure anyways.

By following these guidelines, in a way, you are putting more emphasis on what you are buying the entire firm for when the company is cash rich and debt poor, and emphasis on what you are buying equity in a firm for when the company is debt rich and cash poor. This is what my mentor Steve taught me back in the day. And he called the latter phenomenon where shareholders get progressively better returns as debt is being paid down "Financial Leverage"

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