What is the Price-To-Cash-Flow Ratio
The price-to-cash-flow ratio is a stock valuation indicator that measures the value of a stock’s price to its cash flow per share. The ratio takes into consideration a stock’s operating cash flow (OCF), 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.
The price-to-cash-flow ratio is calculated as:
What Is the Price-To-Cash-Flow Ratio?
BREAKING DOWN Price-To-Cash-Flow Ratio
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.
The price-to-cash-flow ratio measures how much cash a company generates relative to its stock price, rather than what it records in earnings relative to stock price as measured by the price-earnings ratio. The price-to-cash-flow ratio is said to be a better investment valuation indicator than the price-earnings ratio, due to the fact that cash flows cannot be manipulated easily, as opposed to earnings, which are affected by depreciation and other non-cash items.
For example, consider a company with a share price of $10 and 100 million shares outstanding. The company has an operating cash flow of $200 million in a given year. Its cash flow per share is $200 million / 100 million shares = $2. The company, therefore, has a price-to-cash-flow ratio of share price of $10 / cash flow per share of $2 = 5. This means that the company's investors are willing to pay $5 for every dollar of cash flow.
An alternate way of calculating price-to-cash-flow ratio is by taking the ratio of a company’s market capitalization to its operating cash flow. From the above example, the market capitalization is $10 x 100 million shares = $1,000 million. It follows that the ratio can also be calculated as $1,000 million / $200 million = 5. Notice that this is the same figure we got when we calculated the price-to-cash-flow ratio.
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.
Although there is no single figure that points to 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.