Price multiples are commonly used to determine the equity value of a company. The relative ease and simplicity of these relative valuation methods makes them among the favorites of institutional and retail investors. Price-to-earnings, price-to-sales and price-to-book value are typically analyzed when comparing the prices of various stocks based on a desired valuation standard. The price-to-cash-flow (P/CF) multiple falls into the same category as the above price metrics, as it evaluates the price of a company's stock relative to how much cash flow the firm is generating.
TUTORIAL: Ratio Analysis

Calculating the P/CF Ratio
P/CF multiples are calculated with a similar approach to what is used in the other price-based metrics. The P, or price, is simply the current share price of the firm. In order to avoid volatility in the multiple, a 30- or 60-day average price can be utilized to obtain a more stable value that is not skewed by random market movements. The CF, or cash flow, found in the denominator of the ratio, is obtained through a calculation of the trailing 12-month cash flows generated by the firm, divided by the number of shares outstanding.

Let's assume that the average 30-day stock price of company ABC is $20 - within the last 12 months $1 million of cash flow was generated and the firm has 200,000 shares outstanding. Calculating the cash flow per share (CFPS), a value of $5 is obtained ($1,000,000/200,000). Following, one would divide $20 by $5 to obtain the required price multiple. Also note that the same result would be determined if the market cap is divided by the total cash flow of the firm. (The P/E ratio is a simple tool for evaluating a company, but no single ratio can tell the whole story. See Beware False Signals From The P/E Ratio.)

Different Types of Cash Flow
Several approaches exist to calculate cash flow. When performing a comparative analysis between the relative values of similar firms, a consistent valuation approach must be applied across the entire valuation process. For example, one analyst might calculate cash flow as simply adding back non-cash expenses such as depreciation and amortization to net income, while another analyst may look at the more comprehensive free cash flow figure. Furthermore, an alternative approach to determining cash flow would be to simply sum the operating, financing and investing cash flows found within the cash flow statement.

While the free cash flow approach is the most time intensive, it typically produces the most accurate results, which can be compared between companies. Free cash flows are calculated as follows:

FCF = [Earnings Before Interest Tax * (1 – Tax Rate) + Depreciation + Amortization – Change in Net Working Capital – Capital Expenditures]

Most of these inputs can be quickly pulled (sometimes with some minor calculations) out of the firm's financial statements. Regardless of the approach implemented, it must be consistent. (When trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today. Check out Valuing Firms Using Present Value Of Free Cash Flows.)

Relative Value Analysis
Once the P/CF ratio is calculated, the initial result does not actually reveal anything of great significance to the analyst. Similar to the subsequent procedure for relative value methodologies - which use the P/E, P/S and P/BV multiples - the calculated P/CF must be assessed based on comparable companies. A P/CF of 5 does not actually reveal much useful information unless the industry and stage of life for the firm is known. A low free-cash-flow price multiple may be unattractive for an established slow-growth insurance firm, yet present a solid buying opportunity for a small biotech start-up. Basically, to get a sense if a company is trading at a cheap price relative to its cash flows, a list of appropriate comparables must form the comparison benchmark.

Advantages and Disadvantages of P/CF
There are several advantages that the P/CF holds over other investment multiples. Most importantly, in contrast to earnings, sales and book value, companies have a much harder time manipulating cash flow. While sales, and inevitably earnings, can be manipulated through such practices as aggressive accounting, and book value of assets falls victim to subjective estimates and depreciation methods, cash flow is simply cash flow – it is a concrete metric of how much cash a firm brought in within a given period. Cash flow multiples also provide a more accurate picture of a company. Revenue, for example, can be extremely high, but a paltry gross margin would wipe away the positive benefits of high sales volume. Likewise, earnings multiples are often difficult to standardize due to the variable accounting practices across companies. Studies regarding fundamental analysis have concluded that the P/CF ratio provides a reliable indication of long-term returns.

Despite its numerous advantages, there are some minor downfalls of the P/CF ratio. As previously stated, the cash flow in the denominator can be calculated in several ways to reflect different types of cash flows. Free cash flow to equity holders, for example, is calculated differently than cash flow to stakeholders, which is different from a simple summation of the various cash flows on the cash flow statement. In order to avoid any confusion, it is always important to specify the type of cash flow being applied to the metric. Secondly, P/CF ratios neglect the impact of non-cash components such as deferred revenue. Although this is often used as an argument against this multiple, non-cash items such as deferred revenue will eventually introduce a tangible/measurable cash component. Finally, similar to all multiple valuation techniques, the P/CF ratio is a "quick and dirty" approach that should be complemented with discounted cash flow procedures. (For additional reading, refer to DCF Valuation: The Stock Market Sanity Check.)

The Bottom Line
Analyzing the value of a stock based on cash flow is similar to determining whether a share is under or overvalued based on earnings. A high P/CF ratio indicated that the specific firm is trading at a high price but is not generating enough cash flows to support the multiple - sometimes this is OK, depending on the firm, industry, and its specific operations. Smaller price ratios are generally preferred, as they may reveal a firm generating ample cash flows that are not yet properly considered in the current share price.

Holding all factors constant, from an investment perspective, a smaller P/CF is preferred over a larger multiple. Nevertheless, like all fundamental ratios, one metric never tells the full story. The entire picture must properly be determined from multiple angles (ratios) to assess the intrinsic value of an investment. The price-to-cash-flow multiple is simply another tool that investors should add to their repertoire of value searching techniques. (Find out how a company spends its money and whether there will be any left over for investors. See Analyze Cash Flow The Easy Way.)

Related Articles
  1. Investing Basics

    Free Cash Flow Yield: A Fundamental Indicator

    Free cash flow can measure a business’s performance as if you’re looking at its net income line.
  2. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  3. Mutual Funds & ETFs

    Invesco’s Top Funds for Retirement

    Here's a list of Invesco investments—retirement funds—that may work for you if you have the time to let them mature over the long term.
  4. Stock Analysis

    Top 5 Stocks Listed on the Australian Securities Exchange for 2016 (RIO)

    Uncover five of the stocks listed on the Australian Stock Exchange (ASX) that offer investors the highest potential for above-average profits in 2016.
  5. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  6. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  7. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  8. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  9. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  10. Stock Analysis

    The 5 Best Stocks That Pay Monthly Dividends (PSEC, LTC)

    Get the scoop on five of the best stocks that pay regular monthly dividends, offering investors looking for regular income dividend yields of up to 16%.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  5. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  6. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center