Price to Cash Flow Ratio

“Cash is King” say the bigwigs on Wall Street. That is why the valuation of shares is done on the basis of discounted cash flow model rather than discounted earnings model.

The price to cash flow ratio provides an analyst with a shortcut for finding companies that have been undervalued in comparison to their cash flows.

Analysts can scan through the price to cash flow ratios of a number of companies. Then they can start paying more attention to the companies where these values seem to be abnormally low. This article describes price to cash flow ratio is more detail.

Formula

There are many different measures of what analysts consider to be the true cash flow of the company. Some analysts consider operating cash flow i.e. cash flow generated from regular activities to be the correct measure. Others think that the capital investments that the company needs to make must be separated and the resultant free cash flow provides a better picture of the company’s fundamentals.

Accordingly there are at least two cash flow measures that an analyst can look at and here are their formulas:

Price to Operating Cash Flow = Current Market Price / Operating Cash Flow

Price to Free Cash Flow = Current Market Price / Free Cash Flow

Meaning

The price to cash flow ratio tells the investor the number of rupees that they are paying for every rupee in cash flow that the company earns. Thus if the price to cash flow ratio is 3, then the investors are paying 3 rupees for a stream of future cash flows of 1 rupee each. This cash flow is passed on to the investors as dividend. In case, it is reinvested in the business, it shows up as capital appreciation. Thus cash flow will help the investors gain in one way or another.

Interpretation

• Cannot be Manipulated: The price to cash flow ratio is considered to be a more stringent measure by many. The basic reason being that cash flow cannot be manipulated. Cash in the bank is a fact unlike earnings which are the management’s opinion.

  Charges like depreciation, changes in inventory and revenue policy do not affect the cash position making it the favorite of skeptics.

• No Effect of Compounding: The price to cash flow ratio does not consider the effect of compounding. Once cash is received it can be immediately put to work to earn even more cash. However, the ratio fails to capture this phenomenon.

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