Price to Cash Flow Ratio
This is a complete guide on how to calculate Price to Cash Flow Ratio (P/CF) with detailed analysis, interpretation, and example. You will learn how to use its formula to find out if a stock is currently cheap or expensive.
Definition - What is Price to Cash Flow Ratio?
When attempting to analyze a company’s value, the price to cash flow ratio (P/CF) is a useful metric to use.
It can be utilized to discern which stocks are undervalued and overvalued in various industries.
The ratio incorporates the operating cash flow, which accurately tracks the amount of cash a company brings in by adding non-cash expenses, like depreciation and amortization, back into net income.
It is important to note that there is no benchmark ratio that indicates whether a stock is undervalued or not.
Rather, you must compare the ratio to comparable companies’ ratios to obtain a relative worth.
You can easily calculate the price to cash flow ratio by using the following formula:
Price to Cash Flow Ratio = Share Price / Cash Flow Per Share
As you can see, to calculate the price-to-cash-flow ratio, you merely take the price per share of a stock, and divide it by the cash flow per share.
The number you receive when using this formula is called a cash flow multiple.
A cash flow multiple of 5 means that the company is worth 5x its cash flow. In other words, for every $5 of cash flow, the company is worth $1.
Since this ratio takes the company’s operating cash flow into account, it’s also known as the price to operating cash flow ratio (P/OCF).
To get a better understanding of the price to operating cash flow ratio, let’s look at a practical example.
Suppose Company ABC has a share price of $20 with 50 million shares outstanding. Additionally, Company ABC has $100 million in operating cash flow.
To calculate the P/CF ratio of this company, the two components of the equations, namely share price, and cash flow per share must be obtained.
Share price is given, and cash flow per share can be calculated to be $2 ($100 million / 50 million shares).
Using share price and cash flow per share, we compute the P/CF ratio to be 10.
The ratio value of 10 indicates that for every $10 of cash flow, the company is worth $1.
Interpretation & Analysis
Now, what exactly does the price to cash flow ratio show?
Viewing the price to operating cash flow ratio of one company alone is senseless; it doesn’t give you a vivid picture of the company’s financial health.
However comparing the P/CF ratios of a number of companies in similar industries can be extremely beneficial.
For example, if you are evaluating ten different manufacturing companies, and nine of them have ratios above 20, and one has a ratio of 8, the company with the ratio of 8 could very potentially be undervalued.
If you just calculated the ratio of just one company and got 8, it would not provide you with much information.
But when compared to other similar companies, it can underscore the potentially undervalued company (in this case, the company with a ratio of 8).
Cautions & Further Explanation
Investors must remember that no one ratio or metric is foolproof.
In the previous example, you cannot claim that the company with a P/OCF ratio of 8 is undervalued because its ratio is significantly lower than its peers.
There may be extenuating circumstances as to why the ratio is so low.
For example, the company may be going through a grueling litigation that is suppressing its stock price, or the company may be in the midst of an accounting scandal.
Therefore, it is important to not solely rely on one ratio, and instead, consider all financial metrics when attempting to ascertain a company’s financial health.