Glossary

Accelerated Depreciation

  • Under IRS tax rules, companies may take accelerated depreciation expenses for certain assets
  • For example, the straight line depreciation expense for a $1000 asset with no residual value and a four year useful life would be $250 every year for four years
  • Under an accelerated depreciation schedule, the company may be able to depreciate a higher amount during the early life of the asset.
  • For example, an accelerated depreciation schedule could look like $500, $300, $150, $50
  • Accelerated depreciation may be used in the tax books of the company, but not in its GAAP financials where straight-line depreciation must be used

Adjusted Funds from Operations (AFFO)

  • Financial metric primarily reported by REITs (real estate investment trust)
  • AFFO = Funds from Operations – Recurring Capex
  • AFFO is essentially a recurring free cash flow metric that adjusts for non-cash items
  • REITs are commonly valued using Price / AFFO per share

Capital Expenditures

  • Capital spent on physical items expected to last longer than one year
  • For example, the purchase of a computer would generally be considered a capital expenditure
  • Capital expenditures are recorded in the investing section of the cash flow statement and also increase the balance of Property, Plant, and Equipment on the balance sheet
  • Depreciation expenses are run through the income statement based on the useful life of the asset (see Depreciation)

Depreciation (straight-line)

  • Depreciation = (Capital Expenditure – Residual Value) / Useful Life of Asset
  • For example, the yearly depreciation on a $1000 computer purchase with a four year useful life and no residual value would be $250
  • Depreciation is a non-cash expense in the GAAP income statement
  • See Accelerated Depreciation

Discounted Cash Flow (DCF) Valuation

  • The present value of all future cash flows based on a specific discount rate
  • Essentially, a DCF tells you how much an asset is worth today based on its ability to generate cash flow while adjusting for the timing of those cash flows and the financing cost and risk of those estimated cash flows
  • Therefore, all else being equal, a company that is expected to generate cash flow far in the future and with higher financing costs would generally result in a lower DCF value than a company with near-term cash flows and lower financing costs
  • DCF valuations can be highly sensitive to small changes in inputs, which is likely why a multiples based valuation approach (P/E, P/FCF, EV/EBITDA) tends to be discussed more often by investors

EBITDA

  • Earnings before interest, taxes, depreciation, and amortization
  • EBITDA is calculated as Revenue – Cost of Goods Sold – Selling, General & Administrative Expenses
  • EBITDA is commonly used in valuation metrics such as Enterprise Value / EBITDA

EBITDA Margin %

  • EBITDA Margin % = EBITDA / Revenue
  • The three most commonly mentioned margin metrics are gross margin, EBITDA margin, and operating margin

Earnings Per Share (EPS)

  • EPS = Net Income / Shares Outstanding
  • Stock valuations are often quoted using a multiple of EPS (P/E ratio)

Free Cash Flow (FCF)

  • The cash that a company generates after meeting interest and capital expenditure obligations
  • FCF = Operating Cash Flow – Capital Expenditures
  • As a shortcut, investors commonly calculate FCF as EBITDA – Interest – Taxes – Capex

GAAP – Generally Accepted Accounting Principles

  • The framework that governs accepted accounting practices
  • In the United States, one of the most important principles of GAAP accounting is the concept of accrual based accounting, which strives to match expenses to revenues regardless of the timing of the cash flow.  For example, revenue is recognized in the period in which it is earned regardless of whether or not the company has been paid.  Likewise, commissions associated with that revenue are expensed in the period in which those revenues are recognized even if those commissions have not been paid yet.
  • See Non-GAAP

Gross Margin %

  • Gross Margin = Gross Profit / Revenue
  • Gross Profit = Revenue – Cost of Goods Sold
  • The three most commonly mentioned margin metrics are gross margin, EBITDA margin, and operating margin

Net Income

  • The earnings of a company after deducting all expenses

Net Operating Loss (NOL)

  • Losses incurred by a company are generally allowed to be carried forward in order to offset future taxable income
  • These loss carryforwards are generally referred to as NOLs

Non-GAAP

  • Many US companies choose to report selected Non-GAAP financial metrics, which they feel more appropriately reflect the ongoing size and health of the business
  • For example, many companies report non-GAAP EBITDA (often referred to as Adjusted EBITDA) and non-GAAP net income (often referred to as Adjusted Net Income).  These adjusted metrics often exclude one-time charges that are non-recurring in nature.
  • Additionally, many companies back out stock based compensation from these adjusted metrics although critics of this practice argue that stock based compensation is a regular cost of doing business and should not be backed out

Operating Income

  • Earnings before Interest and Taxes or EBIT

Operating Margin

  • Operating Margin % = Operating Income / Revenue
  • The three most commonly mentioned margin metrics are gross margin, EBITDA margin, and operating margin

Price / Earnings Ratio (P/E)

  • One of the most commonly used valuation metrics
  • Measures the price of a stock relative to each dollar of earnings
  • For example, a $20 stock with $1 of earnings per share (EPS) has a P/E ratio of 20x
  • For reference, the S&P 500 typically trades in a range of 12-17x forward P/E

Price / Free Cash Flow (P/FCF)

  • Common valuation metric that is popular among investment professionals as this metric takes into account non-cash items that may exist in EPS
  • Measures the price of a stock relative to each dollar of FCF
  • For example, a $20 stock with $1.50 of FCF has a P/FCF multiple of 13.3x