EV/FCF ratio: alternative to the classic P/E ratio

Enterprise Value / Free Cash Flow versus Price/Earnings

by Jacques Collin

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1. The P/E ratio

For the price/earnings ratio (K / W) you may have concerns about both the capitalization value as the profits. Think of companies with a lot of cash or with a structurally higher cash profit than the reported net profit.

Because excess cash can represent a large portion of market capitalization, the price factor overratedThe profit factor is simultaneously undervalued, because the reported profit is lower than the cash profit. The P/E appears too high and distorts the evaluation. That's why analysts use the K / W less and less often.

a. The Counter

Capitalization value should actually be the current economic value of a company should reflect the price a potential acquirer would pay right now.

In practice this does not happen because two economic realities are missing: the outstanding long-term debt (LT) and the available cash (including short-term investments and liquid long-term investments such as stocks or bonds).

These factors do weigh heavily on an acquisition price. Two companies with the same capitalization value differ in value if their debt load and cash position differ.

Replacing capitalization value with enterprise value is therefore more realistic and useful for comparing companies with a different capital structure.

b. The Denominator

Profits are sensitive to accounting interventions (interest, interest rate changes, one-time items). They also don't take into account the investments needed to keep the company running.

Therefore, choose a purer standard: Of free cash flow (FCF). That is the amount of cash from operations that remains after payments have been made and can therefore be used freely (reinvestment, dividend, debt reduction, share buybacks, etc.).

An alternative construction:

• Net profit
• + Depreciation and amortization
• − Change in working capital (current assets − current liabilities)
• - Investments in tangible fixed assets

FCF can also fluctuate due to choices (e.g. postponing investments), but remains more reliable then net profit.

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2. EV/FCF ratio

Replace the K / W by the EV/FCF ratio. Like P/E, EV/FCF shows how many years it takes to recoup the investment if the FCF remains the same—or how many times the cash flow is capitalized by the value of the economic asset.

The lower the EV/FCF, the more interesting. Values ​​below 15 (and especially below 10) deserve attention. Benjamin Graham associates a safety margin of approximately 10% with a 34% expected growth rate at 15.

Note: The ratio is less useful for growth companies with low or negative cash flow. In that case, assess whether current investments will yield a return later. Preferably work with trailing twelve months instead of just annual figures.

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3. EV/FCF/G

Because EV/FCF says little about growth, one often corrects with G (grow): EV/FCF divided by the growth rateThis is the EV/FCF variant of the well-known PEG ratio.

Rule of thumb (Peter Lynch): A stock is fairly priced when P/E equals its growth rate. The same principle applies to EV/FCF.

• PEG < 1: undervalued
• PEG ≈ 1: correctly valued
• PEG > 1,25: overrated

Example: P/E = 25 and growth = 25% → PEG = 1. If earnings grow 25%, the P/E falls to 20, and the price rises accordingly. At PEG = 5 (P/E 50, growth 10%), the stock is clearly expensive.

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4. EV/FCF/ROE

Because growth (G) can be uncertain, analysts sometimes use ROE (Return on Equity) as an alternative. The idea remains the same: an EV/FCF lower than the ROE indicates a healthy ratio.

Rule of thumb: EV/FCF ≈ 1 is attractive; 1,5 or higher is less so.

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5. The inverse FCF/EV relationship

Just as with K/W, profit yield used, here one looks at the inverse: FCF/EV, Free Cash Flow Yield.

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6. EV/FCF/(G+Y)

With low growth but high divide PEG sometimes distorts. That's why people use PEGY = P/E / (G + Y). The same reasoning applies to EV/FCF: EV/FCF/(G+Y).

This ratio combines growth rate (G) en dividend yield (Y) and gives a more realistic picture of dividend companies.

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Short FAQ

Is EV/FCF more reliable than P/E — and when (still) not?

Yes. EV includes debt and cash; FCF is closer to actual cash generation than net income. Therefore, EV/FCF often provides a more accurate picture than P/E.
Be alert to: early growers with (still) negative FCF, turnarounds, highly cyclical sectors, years with exceptionally high CAPEX, and banks/insurers (FCF less comparable). Use TTM figures or a multi-year average, and set the bar at ROIC > WACC (value creation).

How do I calculate enterprise value (EV) and free cash flow (FCF) in practice?

EV = market capitalization + interest-bearing debt (LT + KT, incl. leases) + minority interests − cash and short-term investments.

FCF (practical) = operating cash flow − CAPEX (maintenance + growth).
Alternative: Net profit + depreciation/amortization − change in working capital − CAPEX.
Work with TTM or a multi-year average and normalize one-off items.

What is a “good” EV/FCF, and when do I choose variants (EV/FCF/G, FCF/EV, EV/FCF/(G+Y))?

Guidance: 20% more expensive (context and sector remain key). Pay attention to the trend (downward is positive).

EV/FCF/G: for predictable growth; target value ~ 1 (PEG logic).

EV/FCF/(G+Y): for low growth but high dividend; combines growth and dividend yield.

EV/FCF/ROE: sanity check; ≈1 is healthy, much higher is less attractive.

FCF/EV (yield): compare the free cash flow yield with alternatives (bonds, risk-free rate).
Negative FCF? Use different metrics and wait for stable cash flow.

Jacques COLLIN

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Financial figures are easier to understand if the fundamentals are sound.
So feel free to start with our
investing guide for beginners.