What is the 'Price-To-Cash-Flow Ratio'
The price-to-cash-flow ratio is the ratio of a stock’s price to its cash flow per share. The price-to-cash-flow ratio is an indicator of a stock’s valuation. Although there is no single figure to indicate an optimal price-to-cash-flow ratio, a ratio in the low single digits may indicate the stock is undervalued, while a higher ratio may suggest potential overvaluation. The ratio takes into consideration a stock’s operating cash flow, which adds non-cash earnings such as depreciation and amortization to net income. It is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges.
BREAKING DOWN 'Price-To-Cash-Flow Ratio'
For example, consider a company with a share price of $10 and 100 million shares outstanding. The company has net income of $125 million in a given year, and operating cash flow of $200 million. It therefore has cash flow per share of $2 (i.e. $200 million / 100 million shares) and EPS of $1.25 ($125 million / 100 million shares). The company therefore has a price-to-cash-flow ratio of 5 (i.e. share price of $10 / cash flow per share of $2) and a Price / Earnings ratio of 8 ($10 / $1.25).
An alternate way of calculating price-to-cash flow is by taking the ratio of a company’s market capitalization to its operating cash flow. From the above example, it follows that the ratio can also be calculated as = $1,000 million / $200 million = 5.
The optimal level of this ratio depends on the sector in which a company operates, and its stage of maturity. A new and rapidly growing technology company, for instance, may trade at a much higher ratio than a utility that has been in business for decades. This is because although the technology company may only be marginally profitable, investors will be willing to give it a higher valuation because of its growth prospects. The utility, on the other hand, has stable cash flows but few growth prospects, and as a result trades at a lower valuation.