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
Price to cash flow =Market
capitalization /Operating cash flow
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
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
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
Free cash flow = Net income +
amortization/Depreciation- changes in working capital-
Free cash flow =Operating cash flow- Capital
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