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I have been investing since 1998 (age 16) when I saved nearly all my money from working on my winter break from high school, and invested it according to the value investing principles I had read about in Warren Buffett’s shareholder letters and books about value investing. After high school, I... More
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  • February 28th, 2009 Newsletter: A Note on Free Cash Flow Yield: 0 comments
    Apr 10, 2009 5:32 PM

    In my last newsletter, I mentioned that I targeted a 14% pre-tax equity free cash flow yield on investments. One important concept that I failed to mention is that the 14% applies not only if the investment is in a good company, but a good company without significant amounts of debt. Debt increases the risk of owning the equity, as lenders receive interest and principal payments before the equity holders receive their return. I will use Susie and Alice’s bakeries to illustrate this concept. Let’s say it costs Susie and Alice $100k each to open their bakeries, and that each generate $30k of cash flow (their return on invested capital is the same). However, let’s say Susie borrows $50k of the $100k at a 10% interest rate and Alice finances it all with equity. Below is an illustration of the cash flows the equity investors in Susie’s and Alice’s bakeries would receive.

      Susie      Alice
    Cash Flow Prior to Interest Payments $30,000 $30,000
    Interest Payments ($5,000) $0
    Cash Flow to Equity Holders $25,000 $30,000
    Equity Invested $50,000 $100,000
    Equity Free Cash Flow Yield 50.0% 30.0%

     

    Leverage looks pretty good at this point. However, let’s consider what happens if everyone in Susie’s and Alice’s town decides to try the latest “no cupcake diet fad” for a year and cash flows decline to $0 for one year.

                                               Susie                           Alice
    Cash Flow Prior to Interest Payments $0 $0
    Interest Payments ($5,000) $0
    Cash Flow to Equity Holders ($5,000) $0
    Equity Invested $50,000 $100,000
    Equity Free Cash Flow Yield -10.0% 0.0%

    Now leverage doesn’t look so great, when Susie is $5k short of paying her creditors. Since leverage is a double-edged sword, investors demand higher returns on companies with significant borrowings in order to compensate them for this added risk. So, while an equity free cash flow yield of 14% works for a good un-levered business, it is likely inappropriate for the businesses with large borrowings. 

     

    I will usually refrain from investing in companies with large borrowings due to the increased risk, but will at least require a higher expected return when investing in them.
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