Price-to-Cash Flow RatioA financial multiple that measures a stock's price relative to the company's operating cash flow per share

Investing in stocks can be exciting.

After all, there is immense potential for earning huge profits when you invest in stocks.

However, it’s not as easy as investing in stocks and then waiting for the profits to come in.

If you invest in stocks without care, you might end up losing on your investment instead.

This is why not everyone invests in stocks. Some even hire experts just so they can safely invest in stocks.

Thankfully, there are tools available for us that can help in assessing and comparing stocks.

One of them is a financial ratio or multiple called the price-to-cash flow ratio (or P/CF ratio).

It measures a stock’s price relative to the operating cash flow per share of the company.

It is especially helpful for assessing stocks of companies that have positive cash flow but a not-so-great net income figure.

For example, a company that has lots of capital assets (which results in having high non-cash expenses such as depreciation).

In this article, we will be talking about the price-to-cash flow ratio.

What is the price-to-cash flow ratio?

How does it help in the valuation of stocks?

How can it help an investor in assessing the value of stocks?

What is the formula for the calculation of a stock’s price-to-cash flow ratio?

We will try to answer these questions as we go along with the article.

What is the Price-to-Cash Flow Ratio?

The price-to-cash flow ratio (or P/CF ratio) is a financial multiple that compares a stock’s price to its company’s operating cash flow per share.

This particular can be used by investors in many ways.

For example, an investor may use it to estimate the amount of cash flow that is available for dividend distribution. An investor may also use it to compare different investment potentials.

The price-to-cash flow ratio uses the company’s operating cash flow instead of its net profit.

As such, it’s especially useful for valuing the stocks of a company that has great positive cash flow but a not-so-great net income figure.

This usually occurs when the company has tons of non-cash expenses such as depreciation, amortization, etc.

Some analysts say that the price-to-cash flow ratio is a better investment valuation tool than the price-to-earnings ratio.

This is because it’s harder to manipulate a company’s cash flow than its net income figure.

To calculate a company’s operating cash flow, non-cash expenses such as depreciation and amortization are added back to its net income.

Another way is to add all operating cash inflows and subtract all operating cash outflows.

The optimal level of the price-to-cash flow ratio will depend on several factors such as the industry where the company belongs and/or its stage of maturity. It’s common to be high for companies that are still in their early stages of development.

These companies will most likely produce low amounts of operating cash flow, but investors value them highly due to their future growth prospects.

There is no general consensus yet on what’s an optimal level for the price-to-cash flow ratio.

However, it is generally accepted that a low figure may indicate that a stock is undervalued. On the other hand, a high P/CF ratio may indicate a potential overvaluation.

The Price-to-Cash Flow Ratio Formula

There are two formulas that we can use in calculating the price-to-cash flow ratio.

One is to use the share’s market price and the company’s operating cash flow per share.

Here is the formula for this variation:

P/CF Ratio = Share Price ÷ Operating Cash Flow per Share

Where:

Operating Cash Flow per Share = Operating Cash Flow ÷ No. of Outstanding Shares

The other variation is to use the company’s market capitalization and its total operating cash flow. Here’s what it looks like:

P/CF Ratio = Market Capitalization ÷ Operating Cash Flow

Where:

Market Capitalization = Share Price X No. of Outstanding Shares

Operating Cash Flow = Net Income + Non-Cash Expenses + Increase (Decrease) in Working Capital

Both formulas should arrive at the same figure.

For example, let’s say that a company’s share price is $8.

It has a total number of outstanding shares of 5 million shares.

In its most recent financial period, it has a total operating cash flow of  $10 million. Let’s compute the price-to-cash flow ratio.

Let’s use the first variation. To do so, we need to calculate first the operating cash flow ratio per share:

Operating Cash Flow per Share = Operating Cash Flow ÷ No. of Outstanding Shares

= $10,000,000 ÷ 5,000,000

= $2

As per calculation, the operating cash flow per share is $2. With this, we can proceed with the computation of the price-to-cash flow ratio:

P/CF Ratio = Share Price ÷ Operating Cash Flow per Share

= $8 ÷ $2

= 4

As per our calculation, the price-to-cash flow ratio is 4.

This means that investors $4 for every dollar of the company’s operating cash flow.

It could also mean that the company’s market value covers its operating cash flow 4 times.

We will now use the second variation.

First, we need to calculate the market capitalization:

Market Capitalization = Share Price X No. of Outstanding Shares

= $8 x 5,000,000

= $40,000,000

The market capitalization is $40,000,000 as per calculation.

We can now proceed with the calculation of the price-to-cash flow ratio:

P/CF Ratio = Market Capitalization ÷ Operating Cash Flow

= $40,000,000 ÷ $10,000,000

= 4

As you can see, both formulas result in the same P/CF ratio which is 4.

The Price-to-Cash Flow Ratio vs The Price-to-Free-Cash Flow Ratio

One needs to note the price-to-cash flow ratio only considers the operating cash flow of the company.

It does not account for the company’s capital expenses.

This can be an issue for very conservative investors who consider a company’s capital expenses in their valuation of stocks.

These investors would rather use the price-to-free-cash flow ratio which is a similar yet more rigorous measure than the price-to-cash flow ratio. Instead of just considering the operating cash flow, the price-to-free-cash flow ratio also considers the company’s capital expenses, which should result in its free cash flow.

This reflects the actual cash flow available for non-asset-related growth.

The price-to-free-cash flow ratio should reflect a higher figure than the P/CF ratio if the company has capital expenses.

This could mean that the investor is relatively paying more for every dollar of free cash flow compared to just the operating cash flow.

The price-to-free-cash flow ratio is particularly useful for valuing companies that are planning to expand their asset base.