What Is a
Valuation Ratio?

Determining whether an investment is
attractive is a multi-step process for investors.

First investors use financial metrics to determine a company’s value. The next step in the evaluation process is typically to standardize those financial metrics, which allows an investor to compare the relative value of one company versus another and determine which potential investment is the most attractive. The most typical means of standardizing these financial metrics is to compare them to the company’s current stock price per share. Below is a chart showing the most common valuation ratios for evaluating stocks, and how they are derived:

How to interpret valuation ratios:

As you can see from this chart and as previously mentioned, financial metrics are typically compared to a company’s stock price per share, with the exception of free cash flow yield. In every case except free cash flow yield, a lower valuation ratio signals that a company is more attractive to investors.

For example, a company with a share price of $29 and $1.80 in earnings per share (EPS) over the last 12 months would have a price to earnings ratio (P/E) of 16.11. All else being equal, this company would be a more attractive investment than a company with a P/E of 18.86 ($33.95 price per share for the same $1.80 in earnings per share). If the earnings of two potential investments are the same, a lower P/E means that an investor is paying less for the same amount in earnings or buying one company at a discount to the other. This pattern holds true for all the valuation ratios listed above except free cash flow yield.

How is free cash flow yield calculated and what is enterprise value?

In order to understand free cash flow yield, you must first understand it’s two component parts: free cash flow and enterprise value. As shown in the chart above, enterprise value is calculated by starting with a company’s market capitalization, adding their total debt, and subtracting the cash on their balance sheet. Market capitalization is the market value of all the company’s outstanding stock. It can be calculated by multiplying the total number of shares outstanding by the price per share.

Enterprise value is a measure of the company’s total value, it can be thought of as a theoretical takeover price if a company were to be bought. It is a more accurate representation of a firm’s value than market capitalization, because when one company purchases another, they’re required to take on the debt of the acquired company and they receive the cash on hand of the acquired company. Free cash flow yield is the exception to the rule of the valuation ratios listed above because a higher free cash flow yield represents a more attractive investment. Free cash flow yield can determine an investor’s payback period. The higher the FCF yield, the lower the payback period for the investor. See the chart below for an example:

Why do we believe free cash flow yield is a superior means of valuing companies?

We believe  using free cash flow yield as a valuation metric is superior to other commonly used valuation metrics because it compares free cash flow, which gives us the most holistic view of a company’s financial well-being, to their enterprise value, which represents the true cost of acquiring a company. This is superior to other valuation ratios which rely on less comprehensive financial metrics and compare those metrics to a company’s stock price per share, which is not an accurate reflection of the true cost of acquiring a company.