In yesterday’s Apple post, I used a basic Bond example to explain the importance of the Discount Rate. The Cash Flows that were discounted in that example (and in any Bond) are obviously the interest & principle payments. These cash flows (especially the higher up on the credit spectrum you go) are pretty certain, especially when comparing them to an Equity. A Bond is a contract – you know you’re getting the contract’s coupon rate (as long as the company doesn’t default,) that’s what you’re getting – nothing more, nothing less.
How about an Equity? What cash flow is the equity investor getting? The Dividend? Most companies make (a lot) more money than what they pay in dividends. Should an Equity not be awarded value for all of that “other” money? What about companies that don’t pay any dividends? Are they worthless?
I’ve read a fair share of research reports, and shockingly seen some analysts mistakenly use EBITDA, or Earnings Before Interest, Tax, Depreciation, & Amortization to value an Equity in their DCF model.
Let’s think about this for minute… It’s the Earnings, BEFORE the company pays Interest (to their Debt Holders), Tax (to the Government), and before deducting Depreciation & Amortization.
Take a look at the Corporate structure. – Debt is senior, while Equity is junior. Debt holders will always get interest payments before the company invests in other things, pays dividends, buys other companies, invests in future products etc. Most bonds even have covenants, &/or mandates restricting the company’s ability as to what they can do with their money.
After the company pays its debt holders their interest, the company then pays taxes.
(Depreciation & Amortization are non cash charges to income.)
The only way you should EVER focus on EBITDA is when you’re looking at the Enterprise Value of a company. (For example, if you’re looking at a buyout or liquidation, you want to know the company’s entire corporate value.)
The Ratio EV/ EBITDA is a tremendously valuable metric as well, it shows the Enterprise Value of the company (Equity AND Debt) divided by the company’s cash earnings. This is the money the company is generating (pretax) that is available to pay ALL STAKE-holders – Equity AND Debt.
However, when you’re looking to discount an EQUITY’S cash flow, EBITDA IS WRONG!
Equity owners don’t have control of all of that money. It isn’t theirs!
For that reason, investors should look at “Free Cash Flow”. Free meaning free to the company – AFTER paying interest on their Debt, & AFTER paying taxes (also not an option to an Equity owner), and even (to be more conservative) take out non-discretionary CAPEX (CAPital EXpenditures which must be made to sustain their current level of business). The only cash flows which should be important to an equity owner is the money that’s left over FOR the SHARE-holders / EQUITY owners.
What the company does with that money is obviously controversial, but whether the company buys-back stock, pays a dividend, or invests in future growth initiatives, all of these activities are FOR the equity owners. (The debt holders on the other hand, would prefer the company hold as much cash as possible to secure their interest payments.)
By properly discounting the Free Cash Flow of any specific company, you can get a fundamental value of what the company’s equity should be worth today. Easier said than done