The price/cash flow ratio (also called price-to-cash flow ratio or P/CF), is a ratio used to compare a company's market value to its cash flow. Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to the price-earnings ratio, this measures provides an indication of relative value.

It is calculated by dividing the company's market capitalization by the company's operating cash flow in the most recent fiscal year (or the most recent four fiscal quarters); or, equivalently, divide the per-share stock price by the per-share operating cash flow. In theory, the lower a stock's price/cash flow ratio is, the better value that stock is.

      Price to cash flow =Market capitalization /Operating cash flow
      or
      Price to cash flow =Stock price per share /Operating cash flow per share

As you can see, the formula includes cash flow instead of net income. In the cash flow of the company, depreciation and amortization are added back. Since amortization and depreciation don't represent an expense that deprives the company of money, the reported cash of the company is artificially reduced. These expenditures are characterized by the fact that they don't involve actual cash. As a result the net income presents a number that is less than the actual cash the company has.

The price to cash flow ratio is a popular method to value stocks. It is similar to the price/earnings ratio. Some analysts consider the price to cash flow ratio superior to the price to earnings ratio.

The reality is that without cash, a company won’t last long. That may seem obviously simple, however there is a long list of companies that failed because cash was in too short supply.

The price to cash flow ratio measures how investors value a company's ability to generate the ultimate "hard" asset (namely, cash), rather than an accountant's definition of profit (namely, earnings).

Cash flow is a popular way to see how well a company is performing excluding distortions caused by accounting. Cash flow is not easily manipulated, while the same cannot be said for earnings, which, unlike cash flow, are affected by depreciation and other non-cash factors.

The price to cash flow ratio is also often considered a better indicator for comparing valuations across sectors, since the price to cash flow ratio is less susceptible to variations in industry accounting practices.

Investors need to remind themselves that there are a number of non-cash charges in the income statement that lower reported earnings. there's no question that the P/E measurement is the most widely used and recognized valuation ratio.

Free Cash Flow Formula

Sometimes free cash flow is used instead of operating cash flow to calculate the cash flow per share figure. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as:

      Free cash flow = Net income + amortization/Depreciation- changes in working capital-

                                 captial expenditures
      or
      Free cash flow =Operating cash flow- Capital expenditures

Price to free cash flow is similar to the valuation measure of price-to-cash flow but uses the stricter measure of free cash flow, which reduces operating cash flow by capital expenditures. This is done as companies need to maintain or expand their asset bases (capital expenditure) to either continue growing or maintain the current levels of free cash flow.

      Price to Free cash flow = Market capitalization /Free cash flow

In order to see how the market valuates the ability of the company to make cash you should divide the current price of the company's stock by the free cash flow per share.

Both of these methods present a useful way to find out the valuation the market assigns to the stocks of a particular company. Depending on the results of the calculations you can determine whether the market has overvalued or undervalued the company.

For example, if the result is a higher number than the numbers of the other companies from the same industry, then it is reasonable to conclude that the market has overvalued the company.

On the other hand, if the result is a lower number as compared to those of the other companies from the same industry, then it is reasonable to conclude that the market has undervalued the company.

These ratios represent only one of the elements of the big picture. No matter how useful they are, you should include other criteria in the evaluation process in order to make sure that valuation is as thorough as possible.