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Overview
Although IRR and MoM often reign supreme as the most popular private equity return metrics, Free Cash Flow Yield is also a very powerful investment metric. Free cash flow is a great tool to use for case study interviews and for returns analyses. And free cash flow can be distributed in the form of carry or dividends, increasing the salary paid to private equity employees.
Free Cash Flow Yield measures the amount of cash flow that an investor will be entitled to. It is mechanically similar to thinking about the dividend or earnings yield of a stock.
A higher free cash flow yield is better because then the company is generating more cash and has more money to pay out dividends, pay down debt, and re-invest into the company. A lower free cash flow yield is worse because that means there is less cash available.
Let’s calculate the yield of a potential investment from the perspective of a private equity firm. If you're interested in working for one of these private equity firms, you should look into our Private Equity Recruiting Course.
To do this exercise, we need two components 1) the Free Cash Flow of the company and 2) the Total Equity Invested. The purpose of this particular analysis is to calculate the yield for an equity investor.
Check out this worksheet, which forecasts FCF Yield of an investment for 5 years:
Free Cash Flow
Free Cash Flow is the real cash available to a company after paying out everything to support typical operations. That means we have to pay down all expenses, we have to pay tax, and we have to pay capital expenditures to keep the business going.
We like Free Cash Flow as a metric because it tries to get to the truest picture of cash. In contrast, net income is a slippery rascal that can be heavily manipulated by accounting magic. EBITDA tries its best, but often ignores crucial items on the cash flow statement.
Different industries will have slightly different definitions for Free Cash Flow, but I find that this is a pretty reasonable definition:
Free Cash Flow Definition
EBITDA
Less: Taxes
Less: Interest
Less: Capex
Less: Increase in NWC
= Levered Free Cash Flow
Note that because we are doing this from the perspective of an equity investor, we also deduct interest. We are investing in equity, so we only care about what is available to equity holders.
If we were investing in the company’s debt or looking at the overall enterprise value, we would not subtract interest. If we don’t deduct interest here, we have Unlevered Free Cash Flow, which is relevant if we are looking at enterprise value.
We deduct Capex and any Increases in NWC because those are real cash costs that the business must make.
Free Cash Flow is the cash that is available to the equity holder. We may decide to reinvest the cash in the business, pay down debt, or even pay a dividend to ourselves for being such well-educated and attractive private equity people.
The formula can differ based on the industry. Just remember that you’ll want to deduct any real cash costs of the business. In software for example, we’ll definitely want to deduct capitalized software costs.
We also need to be especially careful to use the right metric of free cash flow when dealing with preferred securities. We will typically use Levered Free Cash Flow when analyzing the yield to preferred securities, as these preferred securities will be lower in seniority than debt.
Equity Invested
Now that we have Free Cash Flow, let’s compare that to the size of our investment. To illustrate this from a private equity perspective, we’ll need to make some transaction assumptions.
Recall that Enterprise Value is essentially equal to the value of an acquired company. In order to get to our Equity Investment, we’ll want to deduct the company’s Net Debt.
In the below example, the company has a 6.0x Net Debt EBITDA multiple. On an EBITDA of $50, this is equivalent to $300 of Net Debt. The Enterprise Value is $500, so our Equity Investment is $200.
Note that this is a simple transaction where we are buying all of the equity. If there were other preferred securities, we would have to pay out those securities first.
Free Cash Flow Yield
The last thing we have to do is simply calculate Free Cash Flow / Equity Invested. We’ll want to divide for each of the years we have forecasted. This gives us a sense of how the company’s cash flow profile develops over time.
I’ll say that there are no hard and fast rules on what a great FCF Yield is – it often depends on the goal and risk profile of the investor.
Below, you can examine the financial forecast and FCF Yield calculation of a company. The company grows at a revenue of 10% and has an EBITDA margin of 50%. I assume other standard operating assumptions and for simplicity, assume that no debt is paid down.
Here, we see that the FCF Yield goes from 10% in Year 1 to 17% in Year 5.
This looks like a healthily growing business and it’s a good sign that the cumulative levered free cash flow we are generating becomes such a large proportion of our investment. The business is expected to generate $136mm in cash, which gives us pretty good downside protection for our investment.
If our target IRR is a typical 20%, then it’s also a good thing that we’re getting so much cash flow. We’ll still likely get the majority of our proceeds from the eventual sale of the business (which is based on an EBITDA multiple), but this high teens FCF Yield ensures that we’ll be able to pay off a lot of debt.
Conclusion
In conclusion, you should complement your returns analyses by throwing in a FCF Yield calculation. I included FCF Yield in most of the investment committee memos I worked on in private equity.
The issue with IRR and MoM is that they tend to be very sensitive to your exit assumptions and it’s very difficult to predict what kind of exit you’re getting in 5 years.
FCF Yield helps us answer a very important question: how much cash am I actually getting from this company?
