As an investor, I consider myself a bit spoiled. Almost all investors with less than a decade of experience are in the same boat. Very few of us newbies have ever had to actually call up a company and request an annual report. Nor have we had to wait the requisite one to four weeks for it to show up in the mail. If we want data, we get it now. If I want to read McDonald's (NYSE: MCD ) or Starbucks' (Nasdaq: SBUX ) 10-K filing, I need go no further than the SEC website, and it's on my screen in seconds.
We have much more than annual reports at our fingertips. Oftentimes, it's a burdensome amount that I believe is not always helpful. Have you ever punched in the ticker symbol on a financial website, gone directly to the financial summary page, and considered that your quantitative analysis? I'd like to say it's an uncommon practice, but sadly I don't think it is. Many might say it is enough to know what all those figures mean. Who needs to know how they were calculated? For example, does the difference between earnings before interest, taxes, depreciation, and amortization (EBITDA) to enterprise value and free cash flow (FCF) to enterprise value really matter?
EBITDA and FCF
Since EBITDA pops up on many financial summary pages of websites with tools for analysis, it must be important, right? Think again. EBITDA is simply net income with interest, tax, depreciation, and amortization expenses removed from the calculation. Prominent investors such as Berkshire Hathaway's (NYSE: BRK.A ) (NYSE: BRK.B ) Warren Buffett and Charlie Munger have spoken out against the use of EBITDA. Yet, EBITDA lives on. (For an in-depth description of EBITDA, look here and here.)
On the other hand, FCF is a metric that takes net income and removes all of the non-cash expenses, but adds in cash expenses that net income has only partially included over a given period, even though the cash was spent. FCF also reflects the interest and tax expenses that EBITDA ignores, but like EBITDA takes out the depreciation and amortization expenses. Capital expenditures are included in place of depreciation and amortization expenses in the calculation of FCF. To calculate FCF, go to the statement of cash flows for any company and find the amount on the line labeled cash flow from operating activities, and then subtract the amount from the line labeled capital expenditures.
FCF can then be paired with enterprise value to calculate the enterprise value to FCF of a given company. This determines what multiple of FCF a stock is selling for and gives a good first glimpse into a company's current valuation.
EBITDA does not equal FCF
After comparing EBITDA to FCF, it is apparent the two are not the same thing. At best, EBITDA is a bastardization of net income or the accrual accounting measure of profitability, and FCF is simply a measure of cash profitability. However, I recently ran across magazine articles that highlight enterprise value to FCF, but have used EBITDA instead of the FCF described above. Investors beware: If you're making decisions based on one article or web summary of a company, then you're setting yourself up for disappointment later.
Telling the difference
The difference in using EBITDA instead of FCF in enterprise value to FCF calculations can be extreme. Cable operator Comcast (Nasdaq: CMCSA ) is a good example of this. Comcast, like its competitors Cox Communications (NYSE: COX ) and to a lesser extent SureWest (Nasdaq: SURW ) , has a healthy amount of debt from acquisitions and the last few years' large capital expenditures as well. (This is so we can all have broadband and 1,000 cable channels in our living rooms.) Before we go further, remember EBITDA ignores interest, tax expenses, and capital expenditures, while FCF includes all three.
For 2003, Comcast had EBITDA of approximately $9.7 billion, which with a current price around $28 per stub gives Comcast an EBITDA flavor of enterprise value to FCF of 13. This would be near-bargain territory if it were a true enterprise value-to-FCF calculation.
From a pure FCF perspective, we arrive at a very different figure. For 2003, Comcast had cash flow from operating activities of $2.85 billion and capital expenditures of $4.16 billion, giving our enterprise value to FCF a negative number. This is because last year more cash was spent on capital expenditures and other operating expenses than the company was able to collect from customers. The same was also true in 2001, though Comcast did have a marginally positive enterprise value to FCF ratio in 2002.
In all fairness to Comcast and others in the cable industry, these large capital expenditures should eventually end or trail off. At which time Comcast will reap piles of FCF from all of its customers each and every month -- that is, if competitors don't poach the customer first.
Weighing the numbers
Does all of this make Comcast or companies in similar positions bad investments? Not in the least. Enterprise value to FCF is a great tool, but it is not the only determining factor in making an investment. In addition, it is tomorrow's and future years' cash flow that matter most, and that it is true FCF. What is certainly clear is that it pays to dig deeper and spend a few hours with a company's last few annual reports to begin to really understand how the business operates instead of taking the five-minute Internet research route.
Want us to do the math for you? Give any of our investing newsletters a risk-free try today.