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.