Enterprise Value to Cash from Operations (EV/CFO) is an important ratio to assess a company’s cash flow buffer in comparison with its enterprise value. In other words, the ratio helps us in understanding how long it will take the company to acquire existing shares and pay off outstanding obligations, using its operating cash flows.  The estimation of the same requires two main variables: Enterprise Value and Cash from Operations.

Understanding Enterprise Value to Cash from Operations

Enterprise Value reflects the economic value of a company, i.e., it determines the current opportunity cost of the firm. It is the total value of all the assets and liabilities of the firm. In simple words, it refers to the takeover price when a firm is to be purchased, as it accounts for both debt and cash that the acquirer would pocket in the transaction. It is computed by multiplying the share price by the number of outstanding shares in a corporation.

As a reminder, Enterprise Value is calculated as:

Enterprise Value (EV) = Market Capitalization + Total Debt – Cash

Enterprise Value is sometimes mistaken as a company’s market capitalization. But market capitalization of a company solely represents the value of its common equity. The enterprise multiple is comparable to the P/E ratio, but it is more effective for comparing businesses with different levels of financial leverage and evaluating capital-intensive corporations with very high depreciation and amortization. As the P/E ratio is calculated by dividing a business’s market capitalization by its net income, it ignores the firm’s overall worth and isn’t suitable for estimating the value of a company with a high degree of depreciation and amortization.

On the other hand, Cash from Operations tells us how much cash flow is generated by the company’s primary operations rather than supplementary activities like investing and financing. For a firm to remain viable in the long run, it must have a positive cash flow from operations.

Cash Flow from Operations is calculated using the formula:

Cash from Operations= Net Income + Depreciation & Amortization +/- One-Time Adjustments +/- Change in Working Capital

Enterprise Value to Cash from Operations is calculated using Enterprise Value/ Cashflow from Operations

In the case of comparison between similar companies, a lower EV to Cash from Operations (EV/CFO) ratio is preferable. For example, a Company XYZ has 1,000,000 shares outstanding in its balance sheet. The current share price is $10, and the total debt of the company is $2,000,000. The company has a total cash balance of $600,000. Company XYZ’s cash flow statement shows that it recorded $300,000 Cash from Operations last year.

Based on the formula above, we can calculate Company XYZ’s EV/CFO as follows:

(($1,000,000 x $10) + $2,000,000 – $600,000)/$300,000 = 38.

Taking a real-life example, Let’s take a look at the example of Coca-Cola Co., a favorite of Warren Buffet. Coca-Cola’s market capitalization stood at $203.09 billion as of August 23, 2020. The company’s debt in 2019 was $41.1 billion. Coca-Cola’s cash position in 2019 was $13.0 billion. This equates to $28.1 billion in net debt. This gave the company a market capitalization of $231.19 billion. Coca-Cola Co. has an EV/EBITDA ratio of 20.19. A company’s EV/EBITDA ratio should be less than 10. It might also mean that a stock is undervalued. As of January 2020, the S&P 500’s average EV/EBITDA ratio was 14.20. When the S&P 500 and Coca-EV/EBITDA Colas are compared, Coca-Cola’s EV/EBITDA is 6 points higher. As a result, Coca-Cola’s pricing may be expensive.

A higher EV/ Cash from Operations multiple indicates that the firm is likely to be overpriced, while a lower EV/ Cash from Operations multiple indicates that the company is undervalued. In general, the lower the EV-to- Cash from Operations ratio, the more appealing is the firm for investment whereas, a lower EV-to-Cash from Operations ratio indicates that a stock is undervalued.

For instance, two companies Company A and Company B, operate in the automobile industry. The Enterprise Value for Company A is $1000, and for Company B is $800. Cash from Operations for Company A is 150$, and for Company B is 70$. The industry average for EV/Cash from Operations is 10.

For Company A:  EV/Cash from Operations = $1000/$150 = 6.67

For Company B: EV/Cash from Operations = $800/$70 = 11.42

Thus, in the above example, the industry average is 10, while the multiple for Company A is 6.67 and that for Company B is 11.42. Accordingly, we can conclude that Company A’s valuation is on the lower side, while Company B has a higher valuation. Consequently, Company A becomes comparatively an easy target for acquisition.

What’s considered a good EV/CFO ratio?

It’s important to understand that this ratio highlights the cash flow buffer in comparison to the concerned company’s enterprise value. This means a company with a lower EV/CFO value will seem undervalued when compared to a company with a higher EV/CFO value.

Having said that, this is an industry-specific metric and there are no defined values while analyzing a target company. In a consumer products business, an EV/Cash from Operations multiple of 10.0x may be considered excessive, while for a software business, an EV/Cash from Operations multiple of 10.0x may be on the lower end. As a result, the valuation multiple interpretations are all relative, and additional in-depth assessments are required before jumping to a conclusion whether a firm is cheap, reasonably valued, or overpriced. As a result, comparisons of a company’s EV/Cash from Operations multiple should be limited to firms that have similar features and operate in related industries.

This metric is useful for identifying the current multiple at which a business is trading, comparing the valuations of companies, and determining the target price for a firm while preparing an equity research report and in case of determining the purchase price of a private corporation. A major benefit of using this ratio is that it works well for evaluating steady, established enterprises with modest capital expenditures. Since the data needed is publicly available, the estimation of the same becomes easy to compute. It can also be used for comparing the relative valuations of different firms and businesses.

Since every coin has two sides, this ratio also has some disadvantages, i.e., it is not a preferable option when it comes to comparing companies with different levels of capital intensity. If we take two capital-intensive companies generating the same Cash from operations, the one that requires more capital to achieve that level of Cashflow will reflect a lower EV to Cash from operations ratio, making the comparison less viable. Also, using this multiple excludes expenses such as depreciation and amortization, which understates a company’s capital intensity. This criticism is aimed mainly at businesses that must make significant capital investments regularly, such as hotels.

Thus, while establishing a company’s worth, the EV/EBITDA ratio may be quite beneficial. This ratio uses stems from the fact that it considers various elements that make it more complete than the P/E ratio. These elements mainly include contributions from outside lenders rather than solely finance provided through equity shares in the firm. Before any further payments must be made, the ratio offers a raw and obvious value. The EV/EBITDA ratio is for investors who want to estimate a company’s value more thoroughly.