Foundations · F11 · 9 min
Corporate finance for traders
Work out a company’s enterprise value, free cash flow and cost of capital, and say what a debt-funded buyback does to its bonds.
In the news: Company results, share buybacks and takeovers: the news that moves share prices and company bonds.
The essentials
- EBIT and EBITDA
- EBIT is profit before interest and tax. Add back depreciation and amortisation, charges that use no cash, to get , a rough measure of the cash a business makes: £200m + £50m = £250m.
- Free cash flow
- Cash left for lenders and shareholders after tax, new equipment (capex) and the stock and customer credit a business funds: £600m of EBIT taxed at 25%, plus £200m of depreciation, less £250m of capex and £50m of working capital, is £350m.
- Equity value and enterprise value
- Equity value is the share price times the number of shares: 500m at £8 is £4bn. adds , debt minus cash: with £2bn of it, £6bn.
- Valuation multiples
- is the share price over ; a P/E of 20 is an of 5%. values the whole business, so it compares companies with different amounts of debt.
- WACC
- The blended cost of a company’s equity and after-tax debt, weighted by how much of each it uses: 60% equity at 10% and 40% debt at 5% gives 8%. It is the rate used to value its future cash.
- Leverage and buybacks
- Credit traders watch net debt ÷ EBITDA. On £0.8bn of EBITDA, a £1bn debt-funded lifts it from 2.5× to 3.75× while EV barely changes, so the tends to widen.
Enterprise value and free cash flow
EV = equity value + debt − cash; FCF = EBIT × (1 − tax) + D&A − capex − ΔWC
- D&A
- depreciation and amortisation: charges that use no cash this year
- capex
- spending on equipment and other long-lived assets
- ΔWC
- the rise in working capital: stock and unpaid customer bills, minus unpaid supplier bills
How it works
1. What a company earns
A company sells £1,000m of goods and its running costs come to £800m. That leaves £200m of profit before interest and tax, called EBIT. Take off interest and tax and what is left belongs to shareholders: its net income.
2. Costs that use no cash
A machine bought for £100m and used for ten years is charged at £10m a year: that is depreciation (for things like software, amortisation). No cash leaves in those years. Add these charges back to EBIT and you get , a rough measure of the cash the business makes.
3. Free cash flow
To keep going, a business must keep buying equipment (capex) and fund its stock and unpaid customer bills. Take profit after tax, add back depreciation, subtract capex and any rise in that stock and those bills, and you have : the cash left for lenders and shareholders.
4. What the shares are worth
The value of all the shares is the share price times the number of shares: 500m shares at £8 is £4bn. That is the company’s equity value, what buying every share would cost.
5. What the business is worth
Buy the whole company and you take on its debt, but you also get its cash. So the price of the business, its or EV, is equity value plus debt minus cash. Debt minus cash is . £4bn of equity, £2.5bn of debt and £0.5bn of cash give an EV of £6bn.
6. Comparing companies
To compare companies of different sizes, divide value by profit. The is the share price over profit per share: £20 against £1 is 20; flipped over, that is an earnings yield of 5%. does the same for the whole business, so it suits companies with different amounts of debt.
7. The cost of money
Lenders want interest; shareholders want more, because they are paid last. Blend the two by how much of each the company uses, counting debt after tax (interest × (1 − tax rate), since interest cuts the tax bill), and you get its , the weighted average cost of capital: the rate used to value its future cash.
8. Borrowing to buy back shares
A company borrows £1bn and uses it to buy back £1bn of its own shares, a . Debt rises £1bn and equity value falls £1bn, so EV barely changes. But the same profits now support more debt, so lenders face more risk and the extra on its bonds, its , tends to widen.
9. What each trader reads
On results day, share traders compare sales, profits and the company’s outlook with forecasts. Bond traders watch cash flow and , net debt ÷ EBITDA: £3bn of net debt on £1bn of EBITDA is 3×. A profit beat that comes with much more debt can be bad news for the bonds.
Worked example
A company has 500m shares at £8.00, £2.5bn of debt and £0.5bn of cash. EBITDA is £800m, EBIT £600m, the tax rate 25%, D&A £200m and capex £250m, and working capital rises £50m. It borrows £1bn to buy back shares.
- Equity value = 500m × £8.00 = £4.0bn.
- EV = £4.0bn + £2.5bn − £0.5bn = £6.0bn.
- Free cash flow = £600m × 0.75 + £200m − £250m − £50m = £350m.
- Leverage before: net debt £2.0bn ÷ EBITDA £0.8bn = 2.5×.
- After the buyback, net debt is £3.0bn: £3.0bn ÷ £0.8bn = 3.75×, while EV stays about £6.0bn.
EV of about £6.0bn and free cash flow of £350m; the buyback leaves EV unchanged but lifts leverage from 2.5× to 3.75×.
Check yourself
9 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Why compare companies on EV/EBITDA rather than P/E?
A company borrows to buy back shares. What happens to its EV and its credit spread?
Which line of a company’s results would a credit trader read first?
Remember
EV = equity value + net debt
Financing choices move value between shareholders and bondholders: credit traders watch leverage, equity traders watch earnings.