1. Valuation Consistency
Let's look at the allocation of cash flows between investors of the company.
We start with assets, which can be funded by either debt or equity,
but how do we allocate profits or cash flows through the debt or
equity investors? The operating assets of the business generate 100% of
the cash flow, and the cash flow is available to all types of
investors initially. Like who gets paid out first?
Well, we have the debt investors and then the equity investors,
so in this extremely simple example, 25% of the cash flow that's available
from the businesses assets gets first paid to the debt investors,
and the remaining 75% is available to be paid to equity shareholders.
And this is just a simple example that shows the debt investors have
a higher priority on the cash flows of the business
relative to equity investors. However, that's not quite how it works in
the real world, as there are other stakeholders that will be paid first.
Now, let's look at how this really flows through the income statement.
So here's a company, with the same capital structure on the left,
and on the right, we have the income statement.
We've got revenue, operating expenses, depreciation, interest expense,
taxes, and finally, the bottom line, net income.
Let's look at how this gets divided up.
Operating expenses are paid first to vendors and employees.
The employees and vendors of the business typically get the first crack
at the cash flow the company generates. After that, depreciation is deducted.
This is of course, a non cash expense we must include due to
accrual accounting. Next, the interest is paid, and that goes to the debt
holders. After interest expense, taxes are paid to the government.
Now finally, what's left is the net earnings or net income,
which can go to the shareholders of the business.
So how does this flow through to enterprise value and equity value?
Well, we will discuss multiples in more detail in a later lesson,
but it's crucial to understand the next concept.
If you think of an enterprise value to sales multiple or an enterprise
value to EBITDA multiple, if the denominator is before interest expense,
then you use an enterprise value multiple. The reason being is that interest
has not been paid yet, so this metric includes cash flow that's available
to both debt and equity investors. Conversely, if the denominator is a metric
that's after interest expense has been paid, then it's an equity value in
the numerator. For example, price to earnings, earnings are after interest
has been paid. Or price to book value,
book value is shareholders equity. So this is an easy way to quickly
know if you're looking in enterprise value multiple, or an equity value
multiple. Has interest been deducted yet or not?
This numerator denominator consistency, also applies to discounted cash
flows, which we will discuss next.
2. Let's practice!