By Richard Loth (Contact | Biography)

The price/cash flow ratio is used by investors to evaluate the investment attractiveness, from a value standpoint, of a company's stock. This metric compares the stock's market price to the amount of cash flow the company generates on a per-share basis.

This ratio is similar to the price/earnings ratio, except that the price/cash flow ratio (P/CF) is seen by some as a more reliable basis than earnings per share to evaluate the acceptability, or lack thereof, of a stock's current pricing. The argument for using cash flow over earnings is that the former is not easily manipulated, while the same cannot be said for earnings, which, unlike cash flow, are affected by depreciation and other non-cash factors.

Formula:


Components:


The dollar amount in the numerator is the closing stock price for Zimmer Holdings as of December 30, 2005 as reported in the financial press or over the Internet in online quotes. In the denominator, the cash flow per share is calculated by dividing the reported net cash provided by operating activities (cash flow statement) by the weighted average number of common shares outstanding (income statement) to obtain the $3.55 cash flow per share figure. By simply dividing, the equation gives us the price/cash flow ratio that indicates as of Zimmer Holdings' 2005 fiscal yearend, its stock (at $67.44) was trading at 19.0-times the company's cash flow of $3.55 per share.

Variations:
Sometimes free cash flow is used instead of operating cash flow to calculate the cash flow per share figure.

Commentary:
Just as many financial professionals prefer to focus on a company's cash flow as opposed to its earnings as a profitability indicator, it's only logical that analysts in this camp presume that the price/cash flow ratio is a better investment valuation indicator than the P/E ratio.

Investors need to remind themselves that there are a number of non-cash charges in the income statement that lower reported earnings. Recognizing the primacy of cash flow over earnings leads some analysts to prefer using the P/CF ratio rather than, or in addition to, the company's P/E ratio.

Despite these considerations, there's no question that the P/E measurement is the most widely used and recognized valuation ratio.


Next: Investment Valuation Ratios: Price/Earnings Ratio »



comments powered by Disqus
Trading Center