Price to Cash Flow Ratio
Price to cash flow (P/CF) is a valuation ratio used to assess whether a stock is undervalued or overvalued. It is calculated by dividing the stock price of a company by its (operating) cash flow per share. Companies with lower P/CF ratio in comparison to their industry and competitors is considered a good investment.
Price to cash flow is an alternative to price to earnings (P/E) ratio ratio. Price to cash flow and price to earnings are similar in that both have stock price in their numerator. but they differ because P/E uses earnings per share (EPS) to evaluate attractiveness of a stock, while P/CF uses cash flow per share. Price to cash flow ratio is preferred by many analysts because compared to earnings, cash flows are (a) less prone to manipulation by the company’s management, and (b) are less affected by variation in accounting policies between different companies. Hence, price to cash flow is a more stable indicator of a stock's investment potential. It is especially useful in case of companies who have earnings quality issues.
Price to cash flow ratio can be calculated using the following formula:
|Price to Cash Flow =||Current Stock Price|
|Cash Flow per Share|
Cash flow per share equals cash flows from operations divided by weighted average number of shares of common stock. Operating cash flows are sometimes estimated by adding back non-cash expenses to net income. Sometimes EBITDA is considered as a cash flow proxy because it excludes important non-cash expenses. However, both these approaches ignore changes in working capital.
Dew, Inc. & Frost, LLC are competitors operating under different accounting regimes. Dew is required to present a full-set of financial statements including the statement of cash flows while Frost is required to only present a balance sheet and income statement.
Current price of Dew, Inc. common stock is $50 per share while its cash flows from operating activities (as reported on its cash flow statement) amount to $30 million. The weighted average number of shares outstanding for the period were 2 million.
Frost on the other hand had net income of $20 million and depreciation and amortization of $5 million. The company has 5 million weighted average number of shares and current stock price of $18.
Calculate price to cash flow for both companies.
In case of Dew, we have a full set of financial statements so we can obtain the operating cash flows figure from the statement of cash flows and calculate price to cash flow as under:
Cash flow per share = Cash Flows from Operating Activities ÷ Weighted-Average Number of Shares = $30 million ÷ 2 million = $15 per share
Price to Cash flow Ratio = Current Stock Price ÷ Cash Flow per Share = $50 ÷ $15 = 3.33
In case of Frost, we need to estimate operating cash flows and then work out P/CF as follows:
Cash Flows from Operations = Net Income + Non-cash Items = $20 million + $5 million = $25 million
Cash Flow per Share = $25 million ÷ 5 million = $5 per share
Price to Cash Flow = $18/$5 = 3.6
Stock of Frost, Inc. is overpriced as compared to Dew, Inc. If there is significant fluctuation in EPS and P/E ratio, P/CF can provide useful insight.