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  1. 056Two companies each have EBITDA of 100 and an enterprise value of 900. One spends 10 a year on capex, the other 50. If you could value a business on one metric only, levered free cash flow, EBIT or EBITDA, which would you choose, and which of these two is cheaper?Valuation riddlesCoreWarburg PincusSan Francisco · 2014

    Try it first

    Both trade at 9.0x EBITDA. What are they on EBITDA less capex?

    Show the worked solution

    Choose levered free cash flow, and Company A is the cheaper one. Both cost 9.0x EBITDA, but A keeps 90 after capex and B only 50, so the same 900 buys cash at 10.0x in A and 18.0x in B. After 25% tax the gap holds at 13.3x against 24.0x. Levered free cash flow is the one number that has already paid for capex, working capital, interest and tax: it is what an owner can actually take out.

    What does EBITDA leave out that matters here?

    Picture two taxis, each bringing in Rs 1 lakh a month after fuel and the driver. One is new and needs little upkeep; the other is old and eats half its takings in repairs. Before repairs they look identical, and nobody would pay the same for both. EBITDA is earnings before the business pays for the assets it uses up, so two companies with equal EBITDA can leave their owners very different amounts of cash. Company B spends half its EBITDA just to keep running.

    Same EBITDA, same price: the capex decides which one is cheapCompany A: EV 900100EBITDA-1090less capexEV / EBITDA9.0xEV / (EBITDA - capex)10.0xEV / FCF after tax13.3xCheaper: more cash per rupee of EVCompany B: EV 900100EBITDA-5050less capexEV / EBITDA9.0xEV / (EBITDA - capex)18.0xEV / FCF after tax24.0xDearer: half the EBITDA goes on capex
    Both companies cost 900 for EBITDA of 100, 9.0x, but after capex Company A keeps 90 and Company B keeps 50, so the same price is 10.0x A's cash and 18.0x B's; after tax the gap is 13.3x against 24.0x.

    Why levered free cash flow rather than EBIT?

    EBIT does subtract depreciation, which here happens to equal capex, so EBIT would rank the two correctly. But depreciation is an accounting estimate of past spending, not the cash going out this year, and it ignores working capital, interest and tax. Levered free cash flow is the only one of the three that is cash in the owner's hand after every claim ahead of the owner has been paid. Assume no debt and depreciation equal to capex: A's free cash flow is 100 less tax of 22.5 less capex of 10, which is 67.5; B's is 37.5.

    What is the limit of your answer?

    Say two things. First, one year of free cash flow can be lumpy: a big capex year or a working capital swing can make a good business look expensive. With a single period of data, levered free cash flow is the most honest number, but it is also the noisiest. Second, levered cash flow belongs to the equity, so you compare it with equity value, not enterprise value. In this example there is no debt, so the two are the same; with debt you would divide by equity value instead.

    Where candidates lose it

    Candidates pick EBITDA because buyout people talk in EBITDA multiples all day. The question is built to see whether you know what EBITDA leaves out: on these two companies it gives the same answer for a business that keeps 90 and one that keeps 50.

    The second loss is choosing levered free cash flow and then dividing it by enterprise value. Levered cash is the equity's cash; set it against the equity value, or say clearly that with no debt the two coincide.

    What the interviewer asks next

    • Company B's capex is growth capex for a new plant. Does that change your view?
    • Which of the three metrics would you pick for a bank, and why?
    • How would you adjust one year of free cash flow that includes a large working capital release?

    Asked at Warburg Pincus, Private Equity, San Francisco, 2014 (Wall Street Oasis): If you knew nothing about a company or industry and were able to use one metric as a means of valuation, what would you choose?