The Price-to-Cash flow (P/CF) ratio is a metric that compares the prices of a company’s stock with its operating cash flows. While it is not as popular as the Price-to-Earnings (P/E) ratio, it is still a valuable tool that investors have at their discretion. It is one of the many metrics that can help investors evaluate whether a company’s stock is undervalued or overvalued for decision-making purposes.
In its essence, the P/CF ratio calculates the current price of a stock relative to the amount of cash the underlying company generates from its operations. It works best for companies that have significant non-cash items on their Income Statements, such as depreciation, amortization, tax liabilities, etc. Some experts believe the P/CF ratio is a better indicator of investment valuation compared to the P/E ratio.
How to calculate the Price-to-Cash Flow ratio?
There are two formulas that investors can use to calculate the Price-to-Cash Flow ratio of a company based on the available information. The first formula is as below.
Price-to-Cash Flow ratio = Market price of a company’s stock / Operating Cash Flows per share
Alternatively, investors can also use the market capitalization of a company in the stock exchange to calculate the P/CF ratio.
Price-to-Cash Flow ratio = Market Capitalization / Operating Cash Flows
Whether investors use the former or latter method, the result will be the same.
How do investors use the Price-to-Cash Flow ratio?
The P/CF ratio, while useful, has limited usage. As mentioned above, the P/CF ratio is crucial in evaluating stocks of companies that have high non-cash expenses. Therefore, it allows investors to get a better picture of the company’s operations instead of relying on other metrics. It is because companies, although in losses, may have positive operating cash inflows.
Mostly, investors prefer a stock that has a low P/CF ratio. That is because it indicates a stock is undervalued. However, there isn’t a benchmark or standard for how much it should be. In contrast, a high P/CF ratio may also indicate a company having higher future prospects. However, it may also be an indicator of overvalued stocks.
What are the pros and cons of using the Price-to-Cash Flow ratio?
Investors have to face several pros and cons when using the P/CF ratio. Firstly, it considers the cash flows of a company instead of its profits. Cash flows, as compared to profits, cannot be manipulated by a company’s management to reach a favourable position. Similarly, using cash flows allows investors to use a more standardized figure for comparison as compared to earnings. Overall, ratios based on cash flows provide a better and more accurate picture of a company.
There are also a few disadvantages of using the P/CF ratio. Firstly, there are various types of cash flows that investors can use to calculate the ratio, which may result in inconsistent results. Likewise, it neglects any non-cash items, which might have a role in the company’s performance.
Example
A company with a market capitalization of $100 million and operating cash flows of $50 million will have a P/CF ratio as follows.
Price-to-Cash Flow ratio = Market Capitalization / Operating Cash Flows
Price-to-Cash Flow ratio = $100 million / $50 million
Price-to-Cash Flow ratio = 2.00
Conclusion
The Price-to-Cash Flow ratio is an important metric used by investors to calculate the value of a stock. It provides investors with a more accurate picture of a company’s stock as compared to other ratios such as the Price-to-Earnings ratio.
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