From Schweser Equity Book 3, page 245: Adjusted CFO = CFO + [interest * (1 - t)] Adding back the interest to CFO in the Adjusted CFO equation above indicates that operating cash flow is going both to equity owners and debt holders, i.e. to the whole firm. If operating cash flow is to be directed only to the equity holders then interest paid to the debt holders should not be added back. Keeping this in mind have a look at the Schweser’s P/CFO ratio below: From Schweser Equity Book 3, page 245: P/CFO ratio = market value of equity / cash flow where cash flow = CF, adjusted CFO, FCFE, or EBITDA If we were to slightly reword the equation to: P/CFO ratio = market value of equity / adjusted CFO then this indicates that for a unit of ‘operating cash flow to both equity and debt holders’ there is x amount of equity value. Isn’t this misleading since the equation either needs to add value of debt in the numerator or not use ‘adjusted CFO’ in the denominator? If we leave it the way it is the equation will overvalue the ‘value of equity’. Note: this has been briefly discussed before in the middle of another non-related long thread - never reached a consensus though - so I thought I repost it.
^ it is actually discussed in 2 DEDICATED threads lol… I had the same view as you did, some people agreed, others did not agree but failed to explain so you decide ! and given that CFA does not explicitly show this formula for adjusted CFO I would just not worry about it… I like it when I see guys like me out there, we worry about details and not just memorize formulas… But I also worry cause guys like me can fail the exam, while we are worried about details others are worried about passing the exam…lol
From what I understood, it just listed some common denominators for the ratio, and didn’t pass judgment on their validity. I think that using adjusted CFO (with (1-t)*interest added back) is theoretically unsound, but if it’s in common practice and/or ends up having good predictive power then we need to know it.