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 
- MicroFundy
Really enjoying your new posts. A few questions and comments:
1. What is the difference if you use EBITDA for FCF and then subtract fair value of debt at end to arrive at equity? Is this not an equally relevant method for estimating value of equity?
2. Why focus only on maintenance capex and not include growth capex in the DCF? Do your cash flows include the benefit of the expansionary capex or are you making adjustments to remove the benefits of expansionary capex.
3. I think one of the biggest problems in the DCF is the discount rate. CAPM relies on beta which has a horrible r-squared. There is a lot of room for improvement in the discount rate.
AI
1. You could do that (although i would consider it backwards) for the debt portion. How about taxes?
2. You can do all capex, just suggesting at least doing maintenance. There are many (as I’m sure you know) ways to calculate FCF (point of the post was using FCF vs EBITDA)
3. Agreed. Hinted that a bit with yesterday’s AAPL post.
so for the taxes I actually take EBIT and tax effect for tax shield of depreciation and then add back DA as part of my cash flow adjustments (NWC, Capex, DA, etc.). How come the tech industry gets away with removing stock comp expense as a non-cash item?
Can adjust for it afterwards as well.
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When looking at a valuation based on free cash flow to equity (CFO-CapEx+/-Net Borrowing), how critically do you look at the portion of the FCFE that comes from the net borrowings? Do you have a percentage that might be a red flag for you? Do you recommend FCF over FCFE valuation? My only knowledge on subject is from reading “Equity Asset Valuation” from CFA list. Your practical knowledge is much appreciated! Thanks.
From what i recall, the CFA curriculum outlined the differences & benefits to using each metric pretty well.
Point of post wasn’t which metric of FCF to use, it was that you can’t use cash that is due to Debt holders (& tax) to value Equity.
(Unless as AI mentioned in earlier comment, you subtract the Debt value off the EV in the end.)
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