In fundamental analysis, financial ratios work like a tool in order to find out whether a stock is cheap or not. One of such ratios is price to cash flow ratio or P/CF multiple.
Price to cash flow ratio is a comparison of current market price per share with operating cash flow per share. It’s considered as part of the profitability ratio.
In the first step you have to calculate the operating cash flow of the company. In order to do that, you are required to add income (before extraordinary items) to non-cash expenses such as depreciation and amortization. After calculating operating cash flow, you can find out the price to cash flow ratio.
Price to cash flow ratio or P/CF measures how much an investor is willing to pay for per share operating cash flows of the company.
Price to cash flow ratio is the market value of the stock divided by the total cash flow of the company. This calculation will calculate P/CF ratio on a whole company basis.
To calculate P/CF per share, you need to take market price per share and divide it by the operating cash flow per share.
Mathematical formula to calculate Price to Cash Flow ratio of a stock is given below;
P/CF ratio = Share price / Operating Cash Flow Per share
Operating cash flow per share is calculated by taking the company’s 12 months operating cash flow and dividing it by the number of outstanding shares.
In other words, price to cash flow (P/CF) ratio is an indicator that measures the value of a stock’s price relative to its operating cash flow per share.
As discussed above, you can also calculate it by dividing market capital of the company with the operating cash Flow (OPCF). Market capital can be calculated by multiplying current market price per share with the number of shares outstanding.
You can also get OPCF from the company’s statement of cash flow.
Total number of outstanding shares will be in the company’s financial statements and the market price is the last trading price in the stock exchange.
Many market participants prefer to use this indicator because it’s more difficult to manipulate cash flow than earnings. It’s especially useful for valuing those stocks which are non profitable due to large non-cash expenses but has a positive operating cash flow.
A stock with a high price to cash flow ratio is considered a bad investment. A low price to cash flow multiple implies that the stock is undervalued in the current market.
In order to calculate a stable P/CF ratio, instead of taking the current market price of the stock, few market participants prefer to take the 30 to 60 day average price of the stock.
Why to calculate price to cash flow ratio
Price to earnings ratio (P/E) is calculated to measure the multiplication in which investors are willing to pay for a stock in comparison to a company’s earnings per share or EPS. In other words, Price to earnings (P/E) ratio tells you how much a company records in earnings relative to the current market price of the stock. It’s a good measure but does not hold good for all type of companies.
Earnings can be manipulated by the company. Therefore, a more reliable factor considered by many value investors is operating cash flow. It becomes a more important factor when the company has negative earnings due to non-cash expenses such as depreciation and amortization.
Therefore, the price to cash flow ratio indicates how much a company generates relative to its share price.
Why operating cash flow (OPCF) should be looked at in addition to net profit of a company
Due to accrual basis of accounting, the net profit in income statement does not always equal to the operating cash flow of a company. A company may be showing huge profit in the income statement but may be unable to pay its short-term obligations due to cash shortage.
One of the reasons why net profit can’t be considered in this calculation is because of non-cash transactions in income statements. In this type of case, the company will be showing low profit in the income statement with a net positive cash inflow to the business.
Due to this reason it is mandatory for all listed companies to publish statements of cash flow along with income statements and balance sheets. In this statement, you adjust all noncash expenditure to the net earnings to find out cash flow from operating activities.
As discussed above, investors can take OPCF from the statement of cash flow and compare it with the market value per share to understand the relationship.
You can use following formula to find out OPCF by using company’s profit and loss account in case cash flow statement is not available:
OPCF = net earnings + depreciation + other noncash expenses + change in working capital + amortization
To get per share OPCF, you need to divide OPCF by the number of shares outstanding.
Example of the price to cash flow ratio
Company XYZ Limited’s share price is Rs 1,000 and it has 1,00,000 shares outstanding. The company has an operating cash flow of Rs. 2,00,00,000 for the year.
Operating cash flow per share = Rs. 2,00,00,000 / 1,00,000 = Rs. 200 per share
P/CF ratio = Current market price of the stock / Operating Cash Flow Per share = Rs. 1,000 / Rs. 200 = 5
P/CF ratio of 5 means market participants or company’s investors are willing to pay Rs. 5 for every rupee of cash flow. In other words, the company’s market value covers its operating cash flow 5 times.
You can calculate company price to cash flow ratio on a whole company level. You need to calculate a company’s market capitalization and divide it by its operating cash flow.
In our case, the company’s market capitalization is Rs. 10,00,00,000, which is calculated by multiplying 1,00,000 number of outstanding shares with the company’s current market price of Rs. 1,000.
Now we need to divide Rs. 10,00,00,000 by operating cash flow of Rs. 2,00,00,000. So the P/CF ratio can be calculated as Rs. 10,00,00,000 / Rs. 2,00,00,000 = 5, which is the same as calculated above on a per share basis.
High growth stocks can be traded at a high price to cash flow ratio due to expectation of higher growth in its operating cash flow. A company with stable cash flow may have a lower P/CF ratio compared to a high growth stock.
Many investors often prefer to use free cash flow instead of operating cash flow in order to compare with P/CF ratios. The ratio used in this case is known as Price-to-free-cash flow ratio.
As discussed in our earlier articles, no single ratio can give you a complete picture of the company’s profitability. To know company’s liquidity position, profitability, activity and financial leverage following ratios can be used;
