Treasury Practice

Price to cash flow ratio

Published: Jul 2008

The price to cash flow ratio (P/CF) is used to determine whether a company’s share price is high or low in the context of its cash flow. This measure is useful to investors, as its results provide an indicator for a company’s market value, as well as enabling competitor analysis among companies. Such a ratio can also be used as an indication of the future financial health of a company.

Similar to the price to earnings ratio (detailed in treasurytoday, June 2007), the price to cash flow ratio gives an indication of a company’s value relative to the market. While P/E is a better known measurement, many analysts view P/CF as a more accurate calculation because cash flow is less open to manipulation than net earnings figures. Cash flow is also viewed as a better indication of a company’s financial health.

To calculate P/CF, the following formula is used:

\(P\:/\:CF =\frac{Share\: price}{Cash\: flow \:per\: share}\)

Where cash flow per share is calculated using the formula:

\(\mathrm{Cash\: flow \:per\: share} = \frac{Operating\:cash \:flow\:–\:preferred \:dividends}{Number\: of\: common\:shares\:outstanding}\)

For example, Company A has a share price of 350p per share and its cash flow per share is 30. We can calculate the price to cash flow ratio as follows:

\(\mathrm{Price\: to\: cash\: flow} = \frac{350}{30}=\mathrm{11.67}\)

The resulting figure can be interpreted as indicating that the price that investors must pay for each £1 of cash flow generated by the company is £11.67 in stock. The lower the figure calculated, the more the company may be undervalued and this may present a good opportunity for investment.

One of the major benefits that arise from use of the P/CF ratio is that in using cash flows as opposed to net income, depreciation and amortisation charges are not deducted. As these are non-cash items, this calculation may provide a more accurate view of the company’s cash.

Problems with P/CF

Like many ratios offering an indication of a company’s market value, the price to cash flow ratio is predominantly expressed as a figure for the trailing twelve months (TTM). As such, figures may have altered significantly and provide an imperfect overview for investors’ requirements. In addition, different industries are associated with different P/CF levels.

The use of P/CF as a comparison tool should therefore be limited to comparing companies that offer similar products and services. As is often the case, the price to cash flow ratio should be used in conjunction with other methods of analysis so as to provide a true, more accurate overview of the company in question.

Price to free cash flow

A related ratio is the price to free cash flow ratio. Instead of cash flow, this calculation uses free cash flow. This is the cash that is available to benefit shareholders and is calculated by subtracting capital expenditures from operating cash flow. The price to free cash flow ratio shows how much investors must pay for each £1 of free cash flow.

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