Schweser sais that for use in price to cashflow multiples adjusted cash flow= CFO+(net cash interest outflow*(1-taxrate)) I got a problem with this, we are using it in a ratio that uses the equity market price, so it is actually better if we do not add the interest back… imagine firm A has a CFO of 10, but interest outflow of 5, assume tax of 0 its adjusted cfo would be 10+5=15 now imagine firm B with a CFO of 10, and not interest out flow its adjusted cfo would be 10+0=10 if both firms have the same price in the market, using this adjusted cfo is going to make firm A look better with a lower price to cash flow, but it realy is not better because that extra 5 does not belong to the equity holder anyway…it is going to go to the bond holders ! CFAI books simply say that you need to adjust for comparision purposes bettwen gap firms and ifrs firms. i would remove interest from the CFO of IFRS firm, and not add interest to the CFO of GAAP firm for the reasons above…
you realize that the adjusted CFO is on the denominator… so Co. A will actually LOOK WORSE… since P/CFO will drop 100/15 < 100/10 if both companies had a P=100…
"Co. A will actually LOOK WORSE… since P/CFO will drop " humm, lower price to cash flow is better, your paying less and getting more cashflows… i am pretty sure about that, else i need to find me a new career path… anyway probably just a slip up on your behalf…
nice. can you refer me to a page in either schweser or CFA?
The key here is that under IFRS, interest can be categorized as a financing or operating expense (and would most likely be catagorized as financing expense to make CFO look better) and under GAAP it has to be categorized as an operating cash flow. So, if a company reported under IFRS, it could have a CFO of 10, with interest expense of 5 in financing cash flows. The same company operating under GAAP would have a CFO of 10-5=5 The adjusted CFO just adds back interest expense to a company reporting under GAAP to make a GAAP company’s CFO equivalent to a competitors CFO that reports under IFRS. These multiples are just proxies - note that the EBITDA multiple also includes interest, which is not a cash flow owed to equity holders. The key is that you are using the same denominators for different firms, and comparing the multiples. In your example above, comparing a leveraged company with an unlevered company, a FCFE multiple may make more sense - but that is an analyst judgement call.
@ANDREW PAGE 245 IN SCHWESER, NOT SURE IN CFA AND I AM TOO DRUNK TO FIND IT HAHAHAH, WHEN YOU STUDY 8 HOURS A DAY, YOU EARNED IT TO GET WASTED… @ftwcfa "The adjusted CFO just adds back interest expense to a company reporting under GAAP to make a GAAP company’s CFO equivalent to a competitors CFO that reports under IFRS. " agree on that, but dont you think it is better if insted of adding interest to a GAAP company we subtract interest from an IFRS company to make them the same? my logic is we are deviding by price of equity, thus we should have the cash flow to equity in the numerator, while in reality FCFE is the best proxy…if we insist on using CFO we should not include interest in it…cause interest goes to debt holders
“my logic is we are deviding by price of equity, thus we should have the cash flow to equity in the numerator, while in reality FCFE is the best proxy…if we insist on using CFO we should not include interest in it…cause interest goes to debt holders” I concur with ftwcfa’s explanation - the ‘adjusted CFO’ is just a proxy, as is FCEE and EBITDA. The cash flow from the ‘adjusted CFO’ is not only going to the equity holders but to all of the capital holders of the firm - so adding back the interest makes sense. " …but dont you think it is better if insted of adding interest to a GAAP company we subtract interest from an IFRS company to make them the same?" If we are comparing a GAAP firm with an IFRS firm (which treats interest under CFF) then the above adjusted CFO formula will give us a more accurate comparison - otherwise the difference in results stemming from just doing a straight CFO comparison will have attributed to the ‘interest expense’ exclusion (from an IFRS firm). Not sure what the subtraction will do - but it is not the same as adding back the interest.
"I concur with ftwcfa’s explanation - the ‘adjusted CFO’ is just a proxy, as is FCEE and EBITDA. The cash flow from the ‘adjusted CFO’ is not only going to the equity holders but to all of the capital holders of the firm - so adding back the interest makes sense. " but remmber, using it in a ratio that uses the price of equity in numerator…so you are using a cash flow that goes to everyone but deviding it by equity price…i dont find that good for comparison it is like saying, you have two investments, both cost 10$ the first will generate 5$ profit but must pay 1$ interest the second one generates 5$ profit but must pay 0.5$ interest by keeping the interest in there and doing a P/cashflow both will give you a price/cf of 2 (10/5) but would not you rather take the second investment? which brings me to the point, that rather than adding interest in order to make them comparable, subtracting interest makes more sense…
In your example, the valuation perspective is equity - and thus P reflects the cost for a purchaser of an equity, which is obviously your own assumption given the view towards cost of equity. The P/Cash Flow ratio can also be represented as ‘Price of the firm’ and include interest on the denominator, whereas in your example the proper representation is ‘Price of equity’. I think this is the reason why ftwcfa stated above that you’d probably be better off using FCFE as a proxy for the example you’ve provided.
yeh Schweser page 245 they clearly say that by price/CF ration they meen market price of equity/cash flow then they go on to recommend adding back interest into the CFO in the cases where accounting standards have removed it… thats what i have a problem with, they clearly tell you its an equity perspective…
That could be an oversight on Schweser. Have you checked the errata page? Anyone else see this as an issue?
If anyone is able to shed a light on this that would be great.