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.)
InvestingThere are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
Personal FinanceEven if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
Technical IndicatorsLearn one of the most common methods of finding support and resistance levels.
Investing BasicsA diversified portfolio will protect you in a tough market. Get some solid tips here!
EntrepreneurshipThere are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
Active TradingCompanies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
MarketsLearn how this simple calculation can help you determine a stock's earnings potential.
Forex EducationUncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
Fundamental AnalysisA decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
EconomicsThe tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
Hedge funds have not eroded market opportunities for longer-term investors. Many investors incorrectly assume they cannot ... Read Full Answer >>
Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
Working capital is included in calculating the net present value (NPV) of a company. NPV is the difference between the present ... Read Full Answer >>