Nimayi Dixit
Sep 4, 2018 · 2 min read

So I would consider both free cash flow and owner’s earnings as two different ways of measuring the coupon of the equity bond. I talked about ROE as the coupon rate of the bond. This assumes that owner’s earnings is treated as the coupon. You could also consider free cash flow as the coupon, in which case the coupon rate would be Free Cash Flow / Book (Intrinsic) Value.

Both OE and FCF have their differences and, depending on the type of business you are looking at, will provide different views of the business. Free cash flow looks at the actual cash flowing into (out of) a business over a given period of time. Its about getting down to brass tacks — exactly how much cash does this company generate?

Owner’s earnings can include non-cash revenue, like money that is owed to the business but hasn’t been paid yet, or non-cash expenses, like depreciation. OE can often be gamed through clever accounting so looking at free cash flow can be a way to discipline your analysis and avoid getting duped. But you can also miss a lot of the business value if you only look at FCF. In a sense, OE gives a less “material” picture of the business in the moment, but gives a better holistic view of the economic value added by the business (if it isn’t being purposely gamed).

If you’re thinking of Free Cash Flow / Owner’s Earnings as a ratio, then it is a ratio that is trying to approximate an answer to the following question— how much of the economic value that it created was the company able to turn into cash? Or, to connect it to the bond metaphor, what portion of the equity bond’s coupon is in the form of cash?

Both metrics are trying to measure a company’s ability to generate a return, but are giving importance to different things.

Value is what matters, but cash is what is material.

    Nimayi Dixit

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    Day job: Research analyst covering fintech at S&P Global Market Intelligence. Ideas posted here are my own.