Price to Cash Flow or P/CF as it is known is a relative valuation metric which uses the share price and the cash flow of a company to determine whether the company under consideration is undervalued or overvalued as compared to its peers as well as industry average. Like with other price related valuation metrics, P/CF on its own does not provide any information on its own. For it to provide any valuable information about company’s standing in the industry, it has to be compared with its peers in the same industry. P/CF is very useful where the company has a positive cash flow (cash coming in) but is recording an accounting loss due to high non-cash expenses (depreciation). We shall try to understand this implication as we move forward. As always, knowledge is easily processed when accompanied by an example so let us look at one while we try to understand this ratio in detail.
P/CF is quoted in ratio just like any other standard ratio like P/E or P/B. It is the ratio of Market Price of a share of the company to the cash flow of that company.
P/CF Ratio = Market Price or Traded Price Per Share / Cash Flow Per Share
If we are to multiply both the numerator and denominator by total number of shares outstanding, we get:
P/CF Ratio = Market Capitalization of the Company / Total Cash Flow of the Company
All values are available in financial statements of companies. Cash flow is available in cash flow statement. It can also be calculated by adding all non-cash expenses (Depreciation and amortization) to the net profit/loss of the company. At its core P/CF highlights what the market is pricing investors willing to pay for each unit of cash flow per share. For e.g. a share price of € 100 and a Cash Flow per Share of € 10 has a P/CF of 10. This means that you are willing to pay € 10 per € 1 of cash flow per share. When comparing P/CF of one company with its peers and industry, you determine whether you are paying more for that cash flow or less. You want to be paying less so that when the market recognizes the stock’s fair value, you get higher returns.
Use the following calculator to define the Cashflow per Share to paste the result into the first Price to Cashflow Calculator above:
P/CF is a pretty nifty ratio in that it can highlight good companies in asset intensive sectors which have high churn in assets and consequently high depreciation. A high depreciation causes good cash flow to be hidden as it eats up the earnings due to its non-cash expense nature. To highlight P/CF, we shall compare companies across a capital intensive sector: Utilities. We shall focus primarily on electricity generation in the United States of America and are considering the top companies by revenue: Exelon, Duke Energy and American Electric Power. We shall look at the P/CF of these companies and compare them with their performance over last year. As with other ratios, P/CF is independent of currency as long as both Price and cash flow are in the same currency.
Right off the bat, Exelon has a P/CF below industry average as well as its peers. It is considered undervalued as investors need to pay only $7 per $1 of cash flow instead of $10 which is the industry average. Duke Energy is slightly higher and can be considered slightly overvalued as investors are expected to pay $12 per $1 of cash flow instead of $10. American Electric Power is considered highly overvalued commanding $17 per $1 cash flow per share. This high valuations are subsequently reflected in their performance.
As expected American Electric Power has performed very poorly and Exelon has performed relatively better when compared to its peers. However a simple P/CF ratio is not enough for performance. The company in consideration has to also demonstrate its ability to bring in that cash flow and the revenue and earnings growth of our companies is as below:
As one can see, Exelon has demonstrated excellent revenue and earnings growth, outshining its peers considerably thus leading to a relatively excellent performance.
One of the best advantages of using cash flow and thus P/CF to evaluate companies is that it is extremely hard to manipulate cash flow. Unlike other ratios like P/S, P/B and even P/E which depend on sales, asset value and earnings, P/CF can shine a much truer picture on the company’s health. Sales can be manipulated by aggressive accounting or high discounts, asset value can be manipulated via different depreciation methods and subjective estimates.
Earnings numbers can be massaged as well by managing non-cash expenses as well as including other income. Cash flow however cannot be manipulated. Cash has to come in and go out and that record cannot be tampered with. All fundamental issues with the company like problems in operations, poor margins, high debt, and revenue not being realized are reflected in the cash flow statement and valuation metrics taking cash flow into consideration tend to perform better in terms of accuracy of investment decision.
P/CF has its fair share of drawbacks as well. It has to be compared within the industry as certain industries like consumer durables and luxury goods tend to have high cash flows and thus lower P/CF and others like steel or utilities tend to have higher P/CF. The type of cash flow being considered can also vary basis person to person. Some take only Free Cash Flow (Cash Flow after accounting for capital expenditure and working capital) and some take the whole cash flow into account. This are all minor issues however and on an overall basis, the advantages far outweigh the drawbacks.
A low P/CF ratio is the ideal ratio you should be looking for. Within the industry, the lowest P/CF is considered highly undervalued. However as discussed in our other calculators, no single ratio is the holy grail of financial analysis. One must build a consensus with other financial ratios and valuation metrics to arrive at an investment decision. One thing to be taken into note while looking at a low P/CF ratio is company size and whether that low ratio is due to a one time large cash flow.
A large company has a size advantage in its operations and economies of scale on its side thus leading to larger revenues and cash flows. A small company displaying a low P/CF is something that must be looked at deeply to understand whether the company is generating that large cash due to its operations or through something else.
Cash flow statements also contain cash flows due to debt and equity issues (i.e. selling shares to the public). A large equity issue or large debt inflow will lead to large cash flow number and thus low P/CF. If that is the case, one must take average of this year and last year’s cash flow numbers to smoothen out the one-time cash flow. Alternatively focus only on operational cash flows for all companies and not from financing and investments.
Our premium membership allows you access to our vast repertoire of fair value calculators that will allow you to determine the fair value of the stock in consideration and determine its undervaluation/overvaluation. Markets tend to converge on fair value over time and an undervalued stock will soon find its market price rising to meet its fair value.
One can use Yahoo Finance to get fundamental data and use our free manual calculators below to get fair value of the stocks they are looking at. Alternatively our premium membership will do this job for you hassle free.
One can get our premium membership for as low as € 7.9 per month. Just search for any popular company in the sector you are interested in and check out the industry average P/CF of that company. Using our premium stock screener, you can screen for P/CF greater than the industry average as well as the country you want to focus on.
P/CF is a superior valuation metric that can bypass all manipulation tactics used by companies to hide their subpar performance. It has its drawbacks but the advantages far outweigh them. The important point is to focus on the right cash flow and ignore those coming from equity issue or debt. However no single ratio enough to make an investment decision.
One must look at other metrics like Price to Book value and Price to earnings along many others to arrive at a consensus of valuation. We have over 12 such key financial ratio calculators on our website, all available for free. Calculate the key ratios and build a consensus through them to determine whether a company is truly undervalued or overvalued.
Alternatively, join our premium membership and we will do all of this work for you, providing you various fair values right on your very own premium dashboard.
In my experience, P/CF is pretty useful as a final consensus builder. Companies that usually cook their books or manipulate their numbers tend to have a rosy picture not only in their income statement and sometimes their balance sheet but also in their financial ratios. However, if one can sift through the cash flow and sort out the numbers, you will be able to calculate and compare P/CF ratio which if it supports other financial ratios firmly confirms that the company under consideration is a solid company and will help with your investment decisions regarding the company being undervalued or overvalued.
That does not mean however that if the ratio is not in line with others, the company is hiding something. That just means that one needs to go back and study the business in detail, try and spot any discrepancy in what the management is saying and what is being demonstrated in their numbers and operations and move along the trail from there.
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