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Strategies & Market Trends : Free Cash Flow as Value Criterion
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To: jbe who wrote (214)11/18/1997 12:37:00 PM
From: Pirah Naman  Read Replies (1) of 253
 
jbe:

I agree with, and empathize with, your concern over debt levels. I have previously restricted myself to companies with little or no debt, and have felt uncomfortable with companies I have since bought, simply because of debt levels. (So I'll go back to old restrictions.) But I think your mathematical treatment of debt is somewhat misleading.

> (If you use the concept of "enterprise value" (EV = capitalization + debt - cash, you will see why too much debt can cancel out all or much of the benefit of free cash flow.)

The "cash" in the above equation is cash in the bank. It is not FCF.

When you get a number for FCF for a company, that number is AFTER the payment of interest. The reported earnings have already been reduced by interest payments.

Enterprise value isn't a bad way of considering the risk of leverage, but it too can be misleading. If you were to buy a company in its entirety, you wouldn't necessarily pay off the debt all at once, nor would you remove cash all at once. When you evaluated it, you would more likely consider how much of your cash flow would go to meeting the interest payments. This is the concept behind "interest coverage" which is EBIT/interest payments.

Debt to equity can also be misleading, simply because book value is as prone to "interpretation" as earnings are. And some companies simply have lower book values as a nature of their business, such as software and service companies.

Pirah
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