EV/FCF vs. P/E
Over the past few weeks, I have been thinking a decent amount about Enterprise Value (EV) being far superior for share price valuation considerations than market cap (the P in P/E or P/S ratios). While P/Es get thrown about all over the place and could probably be explained by relatively beginner investors, the use of market cap (the price in P/E) doesn’t account for the ownership dilution due to bondholders having a right to part of a company’s future cash flows (i.e. a net debt position). The converse side of that is that for a net cash position, the debt could be instantly paid off in theory, leaving the entire net cash position as owned solely by (or theoretically distributable to) the shareholders. The simple shift of using EV rather than market cap accounts for this/these factor(s).*
Along with this line of thinking** and with Tinker’s observation of Arista’s present EV/FCF ratio (linked below*** & ****), I have started thinking that EV/cash flow might ultimately be a superior way to determine if companies are overvalued/undervalued compared to P/E (lower ratio generally indicating more undervalued…and lower ratios eventually being corrected by share price rises).
Similarly to PEG “ratios” (or 1YPEG), an estimated future growth rate of the cash flow could be used in an EV/CF/G ratio. The investor’s judgment of the company’s competitive advantage period (CAP****) could then factor into their estimate of the future direction of cash flow growth rate.
I will refrain from going in-depth about cash flow being superior to GAAP earnings for this particular valuation metric, but that could be worth some decent discussion as well. I have yet to test my hypothesis, and also have not yet convinced myself whether simple operating cash flow (OCF) is sufficient for this metric or whether free cash flow (FCF) would be substantially better to the point of warranting calculating FCF rather than simply reading OCF from the cash flow statement.
Ultimately though, use of this method would provide a fair correlation to using a discounted cash flow valuation (often considered the true essence of valuing a business)…while also properly accounting for the percentage ownership of shareholders/debt-holders and giving proper credit for cash that has already been generated and is still maintained by the company.
Last night, Tinker pointed out that with Arista’s $1.5 billion net cash position, ANET is at about a 22.5 on an EV/FCF basis (forward FCF, based simply on Q4 17 x 4). That sounds quite a bit less overvalued than the P/E ratio for ANET…even with “only” about a 35% revenue growth rate. Tinker actually just put up a new post on the NPI board further expounding on his thoughts about ANET’s present valuation, which pairs nicely with my thoughts here (which his posts had influenced)****.
- Also as a small note, if a company has preferred shares, holders of those get paid/have a right to the cash before the holders of common shares as well, but that isn’t something that gets encountered much with stocks that are covered on this board (from what I can tell).
** This thinking was sparked in part by hearing in late January about Amazon passing Apple on an Enterprise Value basis and also by noting Bert’s frequent usage of EV/Sales ratios in his write-ups.
***** Bear’s marginal thinking posts have also factored into my brain traveling down these lines of thinking