Price-to-Cash Flow Ratio

The price-to-cash flow ratio is commonly denoted as P/CF. The P/CF ratio is simply a company's share price divided by its operating cash flow per share.

For the numerator, it is essential to know that the share price is a commonly used metric used to value a publicly-traded company’s stock. 

The operating cash flow per share, serving as the denominator in the ratio, is found by analyzing a company’s financial statements. Specifically, you divide the net cash flow from operations by current liabilities. 

When you divide the share price by the operating cash flow per share, you get an important ratio that can be used for many things in both finance and investing.

The P/CF ratio estimates a company's market value based on its cash flow. Thus, the P/CF ratio can serve as a valuation indicator for companies.

You will learn that the P/CF ratio is a very important financial ratio that can drive investment decisions based on its ability to determine a company’s value position in the markets.

What is the Price-to-Cash Flow Ratio?

The price-to-cash flow ratio is a way to evaluate a company by comparing its share price to its operating cash flow - a crucial component of its balance sheet.

Based on a company’s price in the market, it’s commonly used when investing in the stock market since it is a quick way to check the value of a company’s stock share price based on its cash flows. 

In simple terms, the P/CF ratio shows the amount an investor is ready to pay for the cash flow the company generates.

This ratio shows whether a company's market valuation is reasonable. In other words, it can show if a company is fairly priced, underpriced, or overpriced in the financial markets. 

The share price represents the numerator of the P/CF ratio, and it shows the company's current market value based on the most recently traded stock. 

The operating cash flow of a corporation, or the denominator of the P/CF ratio, shows whether or not the company generates enough money to fund and grow its operations.

Calculating the Price-to-Cash Flow Ratio

Essentially, there are two ways to determine the P/CF ratio. To find the P/CF, we divide the company's total market capitalization by its total operating cash flow.

Use the most recent year to determine the P/CF ratio for relevancy and accuracy. Divide the stock price per share by the operating cash flow per share. 

When using the second method of calculating the P/CF ratio on a per-share basis, it is best to use 30 or 60-day price averages to avoid price volatility. 

A 30 or 60-day average price will capture a more stable stock price that is not distorted by erratic market movements, hence reducing volatility. This ensures an accurate value in the numerator of this ratio calculation.

In the first method, knowing that operating cash flow can be found on a company’s cash flow statement is important. Operating cash flow is typically listed as "Net cash provided by operating activities." 

To find operating cash flow per share in the second method, you simply divide operating cash flow by the total shares outstanding.

Price-to-Cash Flow Ratio Formulas

We can use two methods to find the price-to-cash flow ratio.

We have two formulas because there are two ways of viewing the ratio. P/CF can be viewed as a total market cap over total operating cash flow or the price of one share over operating cash flow per share.

The first formula uses total market capitalization rather than price-per-share in the numerator.

P/CF ratio = (total market capitalization) / (operating cash flow) 

Where

Total Market Cap = (share price) * (the number of outstanding shares) 

The second method is based on the share price in the numerator, which we can find by checking the financial markets to see the most recent trade price of the company’s share.

There are two financial criteria necessary to determine operating cash flow per share.

1. Cash from Operations: Annual operating cash flow for the business

2. Total Diluted Shares Outstanding: the number of shares in circulation overall, considering the impact of potentially dilutive products like options and convertible debt. 

With these elements, we can divide the cash from operations by the total shares outstanding to find operating cash flow per share.

Operating cash flow per share = (cash from operations)/ (total common shares outstanding)

Now that we have all of the elements to calculate the P/CF ratio using the price-per-share method, we can use this formula:

P/CF ratio = price of one share / operating cash flow per share

Price-to-Cash Flow Ratio Example

Let's take the example of XYZ Corporation, a large company.

As we already know, to calculate P/CF, we need two things.

1. The market price of XYZ Corporation's stock 
2. Its cash flow from operations.

For this example, the company’s stock is currently trading at $100 per share, and its cash flow from operations for the last year was $10 billion.

As we know, the P/CF ratio is calculated by setting up a ratio. This is where we divide the market price per share by the cash flow per share. 

First, let's take a step back and calculate the cash flow per share.

Let's assume that XYZ Corporation has 1 billion shares outstanding.

Cash flow per share = cash flow from operations/number of shares outstanding

Cash flow per share = $10 billion / 1 billion shares = $10

Now, calculate the P/CF ratio because we have everything we need. 

P/CF ratio = (Market price per share) / (Cash flow per share)

P/CF ratio = $100 / $10 = 10

In this example, XYZ Corporation has a P/CF ratio of 10, indicating that the stock's market price is 10 times the company's cash flow from operations per share.

This means that investors who buy shares of the corporation are willing to pay 10x the cash flow per share that the company produces. 

Price-to-Cash Flow Ratio Analysis

As we have seen from the above example, the P/CF ratio of XYZ corporation is 10. The P/CF ratio of 10 means that people are willing to buy a share of stock in the company at 10 times the amount of cash flow per share.

Now, you are probably wondering if this P/CF ratio is high. Is it low? Is it good? Is it bad? 

Across the board, all financial ratios must be analyzed according to their industry. Let’s see how we can analyze different P/CF ratios.  When the P/CF ratio is low in its respective industry, investors consider this as a positive sign.

This is because a low P/CF ratio means that the given company’s share price is low compared to its cash flows, meaning that the company's current share price is priced on the lower end at a discount.

In literal terms, a low price-to-cash flow ratio means that the given company's share price is low because it produces more cash flows than expected at its market share price.

Conversely, if the P/CF ratio is high in its industry, the given company has a share price that is higher than its cash flows.

This means people would be paying a relatively higher price to buy the stock than their peers in the sector or industry. In this case, investors would likely infer that the stock is overvalued.

While we can use the P/CF ratio to make interpretations about stocks, it's important to note that the P/CF ratio has limitations.

The P/CF ratio does not consider important factors such as a company's debt, growth prospects, or industry dynamics.

When valuing stocks, investors and analysts consider the P/CF ratio to be a preferable alternative to the price-to-earnings (P/E) ratio. 

We would use the P/CF ratio instead of the P/E ratio because a company's cash flows are less susceptible to manipulation than its earnings. 

Cash flow is generally more significant and reliable than earnings because cash flow shows how profitable a company can be in the future. Conversely, earnings are more volatile and often cannot capture the true financial health of a company.

As you can see, the P/CF ratio is a much better tool for interpreting a stock’s price than many other methods. 

Price-to-Cash Flow Ratio Applications

We have seen in the previous section an example of price to cash flow ratio. But what are the uses of it? Here we will see how to use the P/CF ratio:

1. Valuation Comparison

The P/CF ratio allows investors and analysts to compare different companies since it compares the company's value to its actual cash flow. 

A lower P/CF ratio suggests the stock may be undervalued, while a higher ratio indicates overvaluation.

2. Comparison Analysis

We can use the P/CF ratio for comparison analysis between multiple companies.

This can help you understand how a company's valuation compares to its industry peers regarding P/CF. For investors of any kind, it can assist in identifying potential bargain investment opportunities or overpriced stocks.

3. Historical Trend Analysis

Analyzing the P/CF ratio over time can provide insights into a company's valuation trends.

4. Cash Flow Stability

 A low P/CF ratio may suggest that the company's cash flow from operations is stable and reliable. 

On the other hand, a high P/CF ratio could indicate a more volatile cash flow profile; hence, an investor could assume more risk.

Also, a high P/CF ratio can indicate that a company is in the early stages of development, where a company is valued on future prospects of business rather than cash flow.

Researched and authored by Alex Bellucci | LinkedIn

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

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