I like to call enterprise value to free cash flow the thinking man’s price to earnings (PE) ratio*. Because the PE ratio relies on market capitalization, companies with higher debt loads can look cheaper or more attractive than competitors with less debt. Using enterprise value to free cash flow eliminates this potential distortion.

Investors are essentially purchasing future cash flows, also referred to as profits (or losses in the case of negative cash flows), so a higher enterprise value to free cash flow ratio means investors are paying more for future profits. Conversely, a lower value means investors are paying less and potentially getting a bargain. Enterprise value to free cash flow is best used to compare companies in the same industry or a company to its historical value.

Alert Propeller Skies readers will recall that enterprise value and free cash flow have been calculated already. So, without further ado, behold the 2006 enterprise value to free cash flow of six, count ‘em, six, North American Class I Railroads:

Strangely, CSX and Union Pacific (UNP) are trading at a premium to the industry average, despite generally poor operations. CSX also has the honor of being the only railroad with a negative enterprise value to free cash flow in 2005 and over the last five years, caused by negative free cash flow** in four out of five of those years. All the railroads except CSX and UNP currently have an enterprise value to free cash flow ratio above their five year average. Based on the enterprise value to free cash flow, railroads do not appear to be trading at a discount.

Also see the next post, Quick Ratio, the prior post Enterprise Value, or start at the beginning of the series with Railroad Performance Measures: Operating Ratio

notes:

* The price to earnings ratio is a company’s stock price divided by their earnings. While this gives a rough measure of value, accounting ninjas can produce bogus earnings quite easily.

** While operating cash flow was positive at CSX each year from 2001 to 2005, capital expenditures exceeded operating cash flows. Because railroads are a capital intensive business this is not the end of the world. However, I would like to see some improvement in operating performance measures after these massive capital outlays. Alert Prizzo Skeezy readers will recall that CSX’s operating ratio has been improving, but average train speed - which should benefit from capital improvements like more sidings and double tracking - is obviously not. Because of the lack of clear and broad based improvements in operating performance measures, CSX certainly does not , in my opinion, deserve a premium valuation.