Firm versus Equity (apples with apples)

  • somrhsomrh
    Posts: 986
    So one of the things I've been moving toward is comparing apples with apples and oranges with oranges. So I have preference for ratios that compare 2 equity numbers or 2 firm numbers. Numbers that compare 1 equity number with 1 firm number don't make as much sense to me anymore (unless you're trying to get some sort of leverage ratio like EBIT/interest, debt/assets, etc). Here are some examples:

    Firm numbers:
    • Enterprise Value
    • Invested Capital
    • Assets
    • EBIT
    • FCFF

    Equity numbers:

    • Market Cap
    • Equity
    • Earnings
    • FCF

    Ratios that make sense:

    • EV/EBIT
    • EBIT/Invested Capital
    • EV/FCFF
    • EBIT/Assets
    • P/E
    • P/B
    • ROE
    • P/FCF

    Ratios that don't make sense:

    • Earnings/Invested Capital
    • FCF/Invested Capital
    • ROA (Earnings/Assets)

    Now to attempt to spell out why. I'll use Invested Capital as an example.

    Who financed invested capital?

    I would contend it was financed by both equity and debt (if there's debt involved). So this is a firm number, not an equity number since the invested capital was financed, and is therefore owned, by both stakeholders. So when you look at what kinds of profits it generates you should be looking at the profits available to all stakeholders (EBIT, FCFF, etc), not just those available to equity holders because the equity holders aren't the only financiers.

    If you only look at, say, earnings, then low debt firms will appear to have more profitable assets compared to high debt firms even if the assets are identical. That's because a portion of the high debt firms is going to pay interest. But those interest payments are still economic profits generated by the invested capital. It's just getting divided up between two types of stakeholders.

  • 10 Comments sorted by
  • AntacularAntacular
    Posts: 161

    Would also throw in Price/Sales as one that doesn't make sense either, should use EV/Sales instead.

    So what's an appropriate performance measure of FCF? Use FCFF/Assets or FCFF/Invested Capital? FCFE/Equity?

  • somrhsomrh
    Posts: 986
    I definitely agree on sales; that's definitely a firm number.

    I've been using FCFF/IC which is like the cash equivalent of EBIT/IC.

    I suppose something like FCFE/Equity might work as well. ...or simply ROE.
  • JaeJunJaeJun
    Posts: 2,571
    @somrh,
    Good list. Would you say you use firm ratios for all companies you analyse or only for company with high debt?
  • somrhsomrh
    Posts: 986
    I occasionally look at equity numbers but I prefer the firm numbers because it makes comparison between levered and unlevered firms easier. Here's an illustration (I took some simplification liberties like ignoring taxes but it should be sufficient to illustrate the idea):

    image

    So basically the idea is that this is all the same business but with different capital structures from unlevered to debt/equity=1. I even assumed that cost of debt will go up with leverage (which it does; not necessarily the way I described but it's just an illustration).

    The green highlights are ratios that make sense to use (to me at least). The red ones I don't think are useful.

    Some general observations.
    • Cost of equity increases with leverage. That's what you would expect since levered firms are riskier and therefore require a higher rate of return
    • ROE increases with leverage. Same as above. That's one problem with comparing ROE's of two different firms because you need to account for the leverage factor. But I still think it's useful.
    • EBIT/Assets (EBIT/Invested Capital would apply as well) is the same across the board. That's about what you'd expect. After all, they are all the same business and the assets generate the same cash flows. It just gets divided up differently (between equity and debt holders).
    • ROA is entirely useless (which is why it's marked red). It declines with leverage. So what information does it tell you? I have no idea and have no use for it.
    • EV/Earnings or EV/FCF is just like ROA (in my scenario it's the inverse). I don't know what information that could possibly tell me. Now EV/FCFF would work (which is more like EV/EBIT.
    • PE ratio I think is useful but it won't be for comparing two firms with different capital structures. PE declines with decreased leverage (again, this makes sense since there is more risk.)

    Here's a question:

    Suppose you have two stocks that are in the same line of business, have the same growth prospects, etc, but different capital structures. One is selling at PE of 10 and one is selling at PE of 8. Which one is cheaper?

    My answer that question would be: I don't know; what's the capital structure of each? Because a PE of 10 might be cheaper (say if it were unlevered) versus the PE 8 stock if the PE 8 stock had, say, 1:1 leverage (in which case perhaps it should be trading at PE of 7).

    But with an EV multiple, it's already independent of capital structure so I can easily make the comparison.

  • JaeJunJaeJun
    Posts: 2,571
    The only thing I've had against using firm numbers is that business costs are not included in the numbers. e.g. taxes.

    Maybe I read too many Buffett or value focused books hammering home that FCF should be used and that EBIT,EBITDA numbers are evil.

    It's something I'm figuring out. I see the value of being able to compare levered and unlevered companies by using firm numbers, but do I just want to stick with low debt companies or consider highly leverage companies into my portfolio.
  • somrhsomrh
    Posts: 986
    The only thing I've had against using firm numbers is that business costs are not included in the numbers. e.g. taxes.
    Can you give an example of this? I guess I'm not seeing it.

    In the case of EBIT, I actually do adjust for taxes. I've been using EBIT as a shorthand because I don't see EBI used too often and EBIT(1-t) is just cumbersome to type. So I either subtract taxes from EBIT or I subtract out a tax rate (either the company's effective tax rate or one I choose: say 35%).

    But there is a firm side to the FCF. If you actually think about how CFO is calculated, you start with earnings and then make adjustments. You can always start with EBIT (EBI or EBIT(1-t)) and then make the adjustments. Or the simple way:

    FCFF = FCF + interest + dividends paid on preferred

    That would give cash available to equity + cash flows paid to bond holders (and banks) + cash paid to preferred shareholders.

    You could something along the lines of owners earnings:

    Unlevered Owners earnings = owners' earnings (equity) + interest + dividends on preferred

    That would be what it looks like if you were to go in and buy the whole firm (with equity) since those debt/preferred obligations would vanish.

    Anyway, regarding the whole EBIT tax thing, the two approaches are actually different. For levered firms:

    EBI > EBIT(1-t)

    That's because the current tax law favors debt financing: debt financing actually increases value.

    So EBI is probably more accurate but it's an artifact of the tax laws. EBIT(1-t) will show what firm earnings would be provided that they paid off their debt (thereby negating the tax benefit of the debt). So for comparison purposes EBIT(1-t) might be more appropriate. But it seems to me there are pros and cons to both.

  • Reading through Quantitative Value, where the authors use Gross Profit to Assets as a performance metric, and Gross Profit to Enterprise Value as a valuation metric. I was skeptical at first because a healthy gross profit margin doesn't necessarily translate into a healthy operating and net income margin, but their backtesting results indicate they're both solid metrics to use. GPA certainly makes more sense than ROA. Major negative to the book though is they use FCF/Invested Capital and ROA as other performance metrics for their backtests, rather than ROE and FCFE/Invested Capital. I'll post a review of the book (which is otherwise solid) tomorrow when I finish it. 
  • somrhsomrh
    Posts: 986
    I had a thread on the Gross Profit/Assets metric:

    Gross Profitability

    There's a link to the article in the thread. It's an interesting read.
  • somrhsomrh
    Posts: 986
    Prof Damodaran has a good article on enterprise value: see here.

    In the section on "consistency in multiples" he discusses the same topic as this thread with an accompanied table. See here for just the table.
  • JaeJunJaeJun
    Posts: 2,571
    read that the other day. Good breakdown of how each one is to be used.