…Continuation of Measuring Value Creation Series…
Throughout this series, we discussed at length the reason for focusing on “three quarters from now”. This time-period is the best reflection how the goings-on in today’s business will translate into bottom line financial performance.
Most recently in the series, we discussed how the true value of an enterprise–also referred to as Intrinsic Value–is based on what the cash flows of the business, appropriately discounted, are really going to be. Yet, in my methodology, free cash flow is not explicitly considered in the valuation of the business “three quarter’s from now”. Instead, we use a multiple of EBITDA. Our estimate of the free cash flow “three quarters from now” is just as reliable as EBITDA. Why not do a multiple of cash flow instead of EBITDA?
As I address this question, please note that my methodology is geared toward a facilities-based telecommunications business. A characteristic of this sector is its capital intensity. When business is booming, capital program increases dramatically. It fuels the growth. Investments are being made in the current quarter that are intended to create shareholder value in years to come. Conversely, when business slows, the capital is scaled back. Free cash flow increases dramatically, but growth in coming years looks less exciting.
In boom years, capital can be materially higher than EBITDA even for a highly profitable business. Expansion opportunities are plentiful. Free cash flow “three quarters from now” will be negative. No “multiple of free cash flow” will calculate into a meaningful estimate of valuation.
Conversely, a less profitable business might show higher cash flow because they have few growth prospects. They go into “milk the base” mode. The fact that this business’ cash flow is higher than the rapidly growing one does not indicate a higher value. In fact, the reality is just the opposite.
When we talk more about the choice of “multiple”, we will incorporate growth expectations into the discussion. In this post, I want to cover only the point that free cash flow in any given quarter is prone to be an unreliable measure of the business’ future prospects of producing free cash flow.
So what is a reliable indicator of a business’ propensity to produce free cash flow? EBITDA! If growth prospects slow, a material portion of the EBITDA will translate into free cash flow. Consider two businesses in the same industry sector–say fiber-based telecom. The first has EBITDA that is double that of the second. A good starting point assumption is that the first is worth about double that of the second.
Does this help you understand why so much focus is put on EBITDA? At the same time, I hope it is also beginning to shed light why EBITDA-focus should not overshadow free cash flow. At the end of the day, a business is worth what its free cash flows, appropriately discounted, are really going to be. A multiple of EBITDA is simply a shorthand method for estimating Intrinsic Value. When the sun sets over the horizon, it is Intrinsic Value–not muliple of EBITDA–that will matter.
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Thanks Dan, I’ve never really had a full answer to why EBITDA is the metric of choice for this sector, just partial ones.
I have really enjoyed this series. Thanks Dan
I’ve enjoyed these posts of yours. Thankyou.
Keep up the topics
nice information business, i hope i can use it, good article, thank you for it