When choosing what stock to invest in, it is important to understand whether the stock in question will bring in returns or not. Investors and analysts often make use of a number of ratios in order to determine whether a stock is valuable and capable of generating returns or not. One such ratio that is employed by them is the price-to-cash flow ratio. This article seeks to examine the same.
Defining Price-to-Cash Flow Ratio
A popular stock valuation indicator is the price-to-cash flow (or P/ CF) ratio which calculates the value, or worth, of the price of a stock set against its operating cash flow per share. With the aid of operating cash flow (or OCF), it is possible to account for non-cash expenses including amortization to net income and depreciation. One of the most important uses of the P/ CF ratio is that it helps value stocks that have a positive cash flow but aren’t profitable owing to large non-cash charges.
The formula for the price-to-cash-flow ratio is as follows.
P/ CF Ratio = Share Price / Operating Cash Flow per Share
Calculating the Price-to-Cash Flow (P/ CF) Ratio
In order to not take into account any volatility, this ratio is calculated with the aid of a 30- or 60-day average price as it helps obtain a comparatively more stable stock value that is not skewered by market movements that occur at random.
The trailing 12-month (or TTM) operating cash flow is divided by the number of shares outstanding in order to determine what the OCF is which is then used as the denominator of the ratio of the P/ CF ratio.
Apart from this ratio being calculated on a per-share basis, it can be done for the whole company by dividing its market value by its total operating cash flow.
What Does the Price-to-Cash Flow Ratio Indicate?
This ratio helps make clear the amount of cash a company makes which is relative to its stock price as opposed to what it lists down in earning relative to its stock price which is measured with the aid of the price-to-earning (or P/E) ratio.
The price-to-cash-flow ratio is understood to be a superior investment valuation indicator in comparison to the price-to-earnings ratio as cash flows aren’t capable of being as easily manipulated as earnings are. This is because earnings are impacted by accounting treatment for factors such as non-cash charges including depreciation. Some companies may end up appearing to be unprofitable owing to significant non-cash expenses despite having positive cash flows.
Illustrating the Price-to-Cash Flow Ratio with an Example
Consider the example provided below which features company ABC whose individual share price is INR 100 and has 100 million shares outstanding. The outstanding cash flow for this company amounts to INR 200 million for a given year. Therefore, its outstanding cash flow per share amounts to the following.
INR 200 million / 100 million shares = INR 2.
This means that the price-to-cash-flow ratio is 50 or 50x (as INR 100 share price divided by OCF per share which is INR 2). What this means is that a company’s investors are amenable to the idea of paying INR 50 for each Rupee of cash flow. Else, it means that the firm’s market value accounts for its operating cash flow 50 times over.
The price-to-cash-flow ratio can also be calculated taking into account the company as a whole by taking the ratio of the company’s market capitalization against its operating cash flow. The market capitalization of company ABC, therefore, is INR 100 x INR 100 million shares = INR 10,000 million. Therefore, the ratio can be calculated as INR 10,000 million / INR 200 million = 50.0 which gives you the same result as what you would achieve by calculating the ratio in terms of a single share.
Things to Bear in Mind
The ideal level of this ratio is dependent upon the sector in which the company under consideration operates along with its level of maturity. A new technology company that is growing at an incredibly fast pace, may, for instance, trade at a higher ratio in comparison to a utility company that has been operational for decades. This is because while the technology company may only reap marginal profits, investors might be more likely to give it a superior valuation owing to its possibility for growth. In contrast, while the utility company might generate stable cash flows, its growth prospects may be limited owing to which it trades at a smaller valuation.
There is no one figure that indicates what an optimal price-to-cash flow ratio ought to be. That being said, by and large, a low ratio that lies in the single digits may indicate a company’s stock is undervalued whereas a higher valuation may be indicative of possible overvaluation.
Price-to-Cash Flow Ratio vs. Price-to-Free-Cash-Flow Ratio
The price-to-free-cash flow (P / FCF) ratio is a more comprehensive measure in contrast to the price-to-cash flow ratio. Although it is similar, the P/ FCF ratio is more precise as it makes use of free cash flow (or FCF) which reduces the capital expenditures of a company from its total OCF thereby indicating the actual cash flow available to fund non-asset-related expansion and growth. Companies employ this metric when they need to broaden their asset bases either to expand their businesses or in order to maintain adequate levels of free cash flow.
Investors and analysts must always do adequate research prior to investing in a company such that they are able to generate a return on their investments and not incur any losses. In this regard, tools like the price-to-cash flow ratio are most beneficial as they help indicate the true value of a company’s stock.