Free Cash Flow Conversion Analysis (15:04)

What’s the Problem with EBITDA?

While EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortization – is a common metric in valuations and leveraged buyout scenarios, it is not always accurate.

It’s supposed to be a proxy for a company’s Cash Flow from Operations, because just like with CFO you add back D&A and ignore CapEx. So EBITDA, theoretically, should be close to the company’s recurring cash flow generated by its core business operations.

However, EBITDA also ignores:

• Interest and taxes, both of which could be huge, and both of which ARE reflected in Cash Flow from Operations.
• The Change in Working Capital, which could also be very significant, and which is also reflected in Cash Flow from Operations.
• CapEx – Yes, Cash Flow from Operations also ignores CapEx, but that practice makes both of these metrics less reliable indicators of a company’s discretionary cash flow and ability to repay debt principal.

Solution: FCF Conversion Analysis

To tell how reliably a company turns EBITDA into real cash flow, you can compare its Free Cash Flow – defined as CFO minus CapEx – to its EBITDA, and see what percentage its FCF represents.

For example, for Foot Locker the percentages range from 30% to over 60%, indicating that the company is turning 30-60%+ of its EBITDA into Free Cash Flow each year.

In theory, the higher the FCF Conversion, the better, because it means the company is able to generate more cash flow from its business.

However, it also depends on the source of that FCF Conversion – is it driven by policies where customers pay upfront in cash before products are even delivered? If so, that’s very positive because it means the company gets more cash earlier on, on a consistent basis.

On the other hand, if it’s driven by one-time tax benefits, non-recurring items, or strange Working Capital treatment, none of those is a positive sign.

You can use FCF Conversion to compare peer companies and see which one(s) might be deserving of a higher valuation multiple.

For example, HomeAway has a much higher FCF Conversion (around 100%) than many of its peer companies such as PriceLine and TripAdvisor. So you might argue that it should be valued at a higher multiple, even if its growth rates and margins are similar to those of other companies.

You can also use FCF Conversion to develop or support your investment thesis in a leveraged buyout or growth equity candidate.

For example, we use it in our 7 Days Inn case study to show how the company’s switch to a franchised business model will make it a less capital-intensive business and improve its FCF generation capabilities.

Finally, you can use FCF Conversion to determine how much debt a company can take on, and whether that figure should exceed or be below the median figure for peer companies.

For example, if the peer companies have around 4x Debt / EBITDA but only ~50% FCF Conversion, but the company you’re analyzing has 75% FCF Conversion, perhaps it can afford to take on more debt – maybe up to 4.5x Debt / EBITDA or even 5x Debt / EBITDA.

FCF Conversion is by no means a perfect analysis, but it is a useful tool to assess a company’s ability to generate cash flow and to see how reliable credit-related stats like Debt / EBITDA and EBITDA / Interest really are.