Exploring Mr. Price’s ‘Free Cash Flow to EV Yield’ Metric

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SIMON BROWN: I’m speaking now with Keith McLachlan from Element Investment Managers.

Keith, thank you for joining me early in the morning. Just last week, you wrote your bi-weekly article on Moneyweb discussing Mr Price and the free cash flow to EV [enterprise value] yield. I hadn’t encountered it before, but I found the concept intriguing.

Let’s break it down, starting with the basics: free cash flow and enterprise value. Free cash flow is simply the money that comes in, minus expenses; it represents what a company has left over. While it might not go directly into dividends, it helps in growth and benefits shareholders in the short term.

KEITH McLACHLAN: Good morning, Simon! I’m pleased you found my article insightful. Absolutely, it’s a valuable way to assess a company. When evaluating profits, traditional accounting profits often contain theoretical assumptions that can be misleading.

Thus, we aim to understand what true profits represent, which are likely found in the cash-flow statement. True profits are calculated from cash flow from operations, subtracting expenses and any capital expenditures needed to sustain or grow the business. This is what free cash flow truly represents—cash profits that management can use for acquisitions, debt repayment, dividends, or share buybacks without being obligated to reinvest in the company.

SIMON BROWN: Precisely, that’s exactly it—it’s right there on the label.

As for enterprise value, it combines market capitalization with debt, minus cash. Essentially, if I were to acquire a company, I would pay the market cap and address the debt—which could involve negotiation—but fundamentally, I’d settle the debt. The cash on the balance sheet would be an asset for me.

This represents a true valuation or understanding of what the company is worth; it reflects the total amount one would need to spend to purchase the company entirely.

KEITH McLACHLAN: Certainly! Acquisitions are often spoken about on a cash-free, debt-free basis. That’s exactly it—it reflects the total cost to acquire the business while neutralizing cash and debt considerations.

Another perspective, relevant for the free cash flow to EV ratio, is that enterprise value represents the cost incurred by the funders of the business.

On one hand, there’s equity from shareholders, and on the other, debt from creditors. Thus, the funds are utilized to generate those cash flows while remaining agnostic to how the business is financed.

SIMON BROWN: I appreciate that; the agnostic stance is valuable. This effectively leads to a situation where you have free cash flow relative to enterprise value, presented as a yield—similar to a dividend yield. It indicates the return on your investment.

In Mr Price’s case, the numbers were quite impressive. When compared to the South African 10-year [bond], which represents a risk-free return, it quickly sheds light on where true value lies.

KEITH McLACHLAN: Exactly. The free cash flow we discussed represents a true cash profit, whereas the EV component helps us normalize the ratio across different companies, regardless of their various gearing ratios or amounts of debt or net cash on their balance sheets.

Furthermore, this ratio subtly conveys an interest rate. Conceptually, if this business were to maintain its cash flows at a steady level indefinitely, that yield would represent the return on capital at its current market price—thus making it comparable across diverse asset classes.

Is equity expensive or cheap? That’s a relative inquiry, and this framework allows us to assess it in relation to bonds. For instance, you could hold Mr Price for a decade or opt for a 10-year bond; with the latter, at maturity, you’d simply receive your cash flows and capital back.

In the case of Mr Price, while there’s some uncertainty with the cash flows, you’re likely still invested in the company in 10 years’ time. This approach yields better comparative frameworks, helping us evaluate valuations based on sovereign risk and varied interest rates, which is incredibly informative.

SIMON BROWN: I completely agree—that perspective is crucial. Over the span of ten years, with all else being equal, the bonds might stagnate, but ideally, Mr Price increases its free cash flow, becoming an even more attractive option.

We’ll wrap it up here. Thank you, Keith McLachlan from Element Investment Managers, for the early morning insights.

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