What it means
Free cash flow is the cash left over after a company has paid its operating costs and spent what it needs on equipment and other long-term assets. It is the money that can be paid to lenders and shareholders, used to repay debt or kept for the future.
Enterprise value, as the price of the whole business, is divided by that cash. If the ratio is 15, the business is priced at fifteen times its annual free cash flow, so a buyer would need about fifteen years of unchanged cash flow to recover the price.
The inverse, free cash flow divided by enterprise value, is a cash yield, which can be compared directly with interest rates or the yields on other investments. A 6.7% yield, for example, equals a ratio of 15.
The ratio is helpful where EBITDA hides reality. A business with large capital spending may report strong EBITDA but generate little free cash, and this ratio exposes the difference.
It rewards businesses that convert profit into cash efficiently. There are issues of definition.
Free cash flow is normally operating cash flow minus capital expenditure, but some analysts deduct lease payments or add back interest, and the choice must match the use of enterprise value. If enterprise value includes debt, the cash flow should be measured before interest payments, so that both sides of the ratio relate to all providers of finance.
The ratio can swing widely from year to year. Free cash flow depends on the timing of large purchases and on changes in working capital, so a single year may mislead.
Many analysts use an average over several years or a normalised figure that smooths out unusual spending. It also does not suit every company.
Businesses in a heavy investment phase, such as young growth companies, may have negative free cash flow, which makes the ratio meaningless. In those cases, revenue multiples or other approaches work better.
In practice
Real-world examples
Example 1
An investor compares two industrial companies with the same EBITDA. One spends little on equipment and trades at 12 times free cash flow, while the other spends heavily and trades at 30 times. The investor concludes that the second business is far more expensive in cash terms.
Example 2
A private equity firm is assessing a food distributor. It calculates enterprise value to free cash flow at 11 times and compares this with the 7% interest on the debt it plans to use. The cash yield of about 9% exceeds the interest cost, which supports the deal.
Example 3
A chief financial officer reviewing a possible acquisition averages the target's free cash flow over the last four years. This avoids relying on a single year in which the target delayed investment, and gives a more reliable multiple.
Think of it
EV/FCF shows the total acquisition cost relative to the cash the business generates after maintaining itself.
Formula
Calculation
Enterprise value to free cash flow = Enterprise value / Free cash flow
Free cash flow = Cash flow from operations - Capital expenditure
Suppose a company has enterprise value of $600,000,000, cash flow from operations of $55,000,000 and capital expenditure of $15,000,000.
Free cash flow = 55,000,000 - 15,000,000 = $40,000,000.
Enterprise value to free cash flow = 600,000,000 / 40,000,000 = 15.0 times.
The free cash flow yield is 40,000,000 / 600,000,000 = 6.67% (rounded), meaning each dollar of enterprise value produces about 6.7 cents of free cash a year.Case study
Seen in the real world
Northgate Printing is an illustrative, fictional company that attracted an offer at 9 times EBITDA, which looked cheap to its board. The business reported EBITDA of $20,000,000.
The buyer's analyst found that the company's presses needed about $13,000,000 of capital spending every year, leaving free cash flow of only $5,000,000 after other cash items. With an enterprise value of $180,000,000, the ratio was 36 times free cash flow.
The buyer lowered its offer to reflect the cash reality, and the board, after checking the numbers, accepted a revised price. The illustrative lesson is that a business can look inexpensive on EBITDA and expensive on cash.
Watch out
Common mistakes
- Using free cash flow after interest with an enterprise value that includes debt, which mixes two different bases.
- Relying on a single year's free cash flow when capital spending is lumpy.
- Applying the ratio to companies with negative free cash flow, which gives a meaningless result.
Questions
People also ask
What does a low enterprise value to free cash flow ratio mean?
It suggests the business generates a lot of cash relative to its price, but it should be checked for growth, risk and the sustainability of the cash flow.
How is the ratio related to free cash flow yield?
Free cash flow yield is the inverse of the ratio, so a ratio of 20 equals a yield of 5%.
Why might analysts prefer it to enterprise value to EBITDA?
It reflects capital spending and working capital needs, so it shows more clearly how much cash investors would actually receive.