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The Game Changer

A Key Financial Metric for Use by Savvy Investors

RIIQ Newsletter

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Deep-Dive

Intro

Imagine receiving a text from a friend asking for a quick tip on a stock for investment. Do you just throw out the first company name that comes to mind? Or, like any savvy investor, do you take a moment to dig deeper into the company’s financials to see if it’s really worth their money?

If you’re the latter type, there’s a good chance you’re already familiar with one of the most valuable metrics out there: Enterprise Value-to-Free Cash Flow (EV/FCF).

Not sure what that is? Don’t worry. We’re about to dive into the world of EV/FCF, a financial ratio that savvy investors use to gauge a company’s worth relative to its free cash flow (the actual cash that the company has available after covering expenses).

Spoiler: it’s a game-changer.

What Is It Exactly?

Before digging into the ratio itself, let’s start with Enterprise Value, or EV.

At its core, EV is the total value of a company. It's like the price tag on the company if you wanted to buy the whole thing today, debt and all.

In contrast, market capitalization (the value of a company’s shares) is just one piece of the puzzle. EV goes beyond that by taking into account not only the company’s market cap but also its debt and cash reserves. Think of it as the ultimate "all-in" valuation—one that paints a fuller picture than market cap alone.

How Is It Calculated?

It’s a simple but powerful formula:

So, what does this mean in practice?

Well, if a company has a lot of debt, EV adjusts to reflect that. Similarly, if a company has a large cash reserve, it’s taken off the total EV since that cash is a readily available asset. You wouldn’t pay extra for money that’s already sitting in the bank, right?

What About Free Cash Flow?

As you may already know, next up, Free Cash Flow (FCF)—the star of this show.

FCF is basically the cash a company has left over after paying for its operating expenses and capital expenditures (CapEx). Think of it as the money that “free” to be used for things like paying dividends, buying back shares, or expanding the business. It’s the money that’s truly up for grabs once all the bills have been paid.

The formula for FCF is pretty straightforward:

Note: Operating Cash Flow can easily be attained directly from a company’s Statement of Cash Flows.

Free cash flow is crucial because it tells investors how much actual cash the company is generating. It’s one thing to report profits on paper, but what really matters is the cold, hard cash. A company might be reporting big profits due to accounting practices, but if there’s little free cash flow, there could be trouble behind the scenes.

Putting It Together: The EV/FCF Ratio

Now, for the grand finale: the EV/FCF ratio. This is where the magic happens.

So, why is this ratio important? Well, it tells us how many years it would take for a company to generate enough free cash flow to cover its purchase price (i.e., its EV). The lower the ratio, the faster you, as an investor, could recoup your investment. In contrast, a higher ratio suggests it’ll take longer, which may signal that the company is overvalued.

A Generic Example to Bring It Home

Let’s break this down with a simple example to begin.

Say Company X has an Enterprise Value of $1 billion and generates $100 million in free cash flow annually. Using our EV/FCF formula, we get:

This means that it would take Company X 10 years to generate enough free cash flow to equal its current enterprise value. Not bad, right?

Now let’s look at Company Y, which has an EV of $1 billion but only generates $50 million in FCF. Its EV/FCF ratio is 20, meaning it would take twice as long to generate enough cash to cover its enterprise value. Company X looks like the better deal, doesn’t it?

But what about real life examples to picture this?

First, Amazon's EV/FCF ratio (see graph below) has been on quite the rollercoaster ride from 2019 to 2024, with a dramatic dip into the negatives in 2022-2023. The main culprit? Changes in free cash flow.

During the pandemic, Amazon ramped up spending to meet the surge in demand, especially in e-commerce and AWS (its cloud service), which sent its EV/FCF ratio soaring. But once the pandemic rush cooled off, combined with inflation, rising labor costs, and supply chain headaches, Amazon’s free cash flow went negative, dragging the ratio below zero. On top of that, their massive investments in infrastructure and logistics ate into cash flow, while high interest rates and other economic hurdles didn't help either.

Fast forward to 2024, and things have settled down with a more reasonable ratio of 41.2. This bounce back likely came from cutting back on big spending, running things more efficiently, and a more stable economic environment. In short, Amazon seems to have gotten its free cash flow back on track, making its valuation look a lot healthier.

The negative FCF might be concerning at first glance, but if a company’s investments in R&D pay off, the EV/FCF ratio could improve dramatically in the future.

Why Is It Useful for Investors?

Investors love the EV/FCF ratio for a few reasons.

First, it gives them a much more comprehensive view of a company’s value compared to more traditional metrics like the Price-to-Earnings (P/E) ratio, which only looks at profits. Since EV accounts for both debt and cash, and FCF is a more realistic measure of available cash, this ratio provides a deeper insight into how well a company is actually performing.

Second, this is especially useful for companies in capital-intensive industries—think manufacturing, utilities, or energy. These businesses often have significant non-cash expenses like depreciation, which can distort traditional earnings figures. EV/FCF cuts through the noise and gives investors a cleaner look at what’s really happening with cash flow.

When the Ratio Shines

The EV/FCF ratio is particularly useful in a few scenarios. For one, it’s a go-to for evaluating mature companies that generate consistent cash flow. For example, if you’re looking at a utility company with steady earnings but significant capital expenses, EV/FCF will help you understand if it’s a good investment based on how much cash the company can generate in the future.

Similarly, if a company has high depreciation expenses—common in capital-heavy industries—EV/FCF is better than relying on P/E. Depreciation lowers net income, but it doesn’t affect cash flow. So, a company could appear less profitable on paper when, in reality, its free cash flow is in great shape.

When to be Cautious

Of course, no ratio is perfect. EV/FCF does have its limitations.

For one, it’s highly sensitive to cash flow fluctuations. A company might experience a temporary boost in free cash flow due to a one-time reduction in expenses, which could skew the ratio in its favor. Investors need to be cautious of such short-term anomalies.

Also, some industries naturally have higher EV/FCF ratios due to their growth potential. Technology companies, for instance Microsoft (see graph below), often trade at higher multiples because investors are willing to pay a premium for future growth.

If you’re only looking at EV/FCF without considering industry context, you could miss out on some big opportunities—or end up overpaying for a stock that looks undervalued at first glance.

Useful Across Industries

Different industries come with their own quirks, and EV/FCF reflects that.

As mentioned, in the tech world, high EV/FCF ratios are more common because of the sector’s growth potential. A company may have negative free cash flow because it’s investing heavily in research and development (R&D), but if the market believes that investment will pay off in the long term, a high EV/FCF ratio might still be justified.

On the other hand, industries like utilities or consumer goods, like Procter & Gamble with an actual enterprise value of $426 billion and a free cash flow of $16 billion (see graph below) often have much lower EV/FCF ratios. These companies are usually more stable, with consistent cash flows and less potential for rapid growth, so investors expect a quicker return on their investment.

In Conclusion: the Bottom Line for Investors

The EV/FCF ratio is a powerful tool, but like any metric, it works best when used as part of a broader investment strategy. Investors should consider it alongside other financial ratios and metrics, such as debt levels, industry trends, and future growth potential.

In the end, EV/FCF offers a clearer view of how well a company is converting its resources into cash—the lifeblood of any business.

For investors looking to make informed, long-term decisions, this ratio is a must-have in the toolbox. And next time your friend asks for a stock tip, you’ll have something more insightful than just a company name—you’ll have the numbers to back it up.

Key Insight

Since EV accounts for both debt and cash, and FCF is a more realistic measure of available cash, the EV/FCF ratio provides a deeper insight than the P/E ratio into how well a company is actually performing.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

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