Education: Value Investing

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Defining the Price-to Cash Flow Ratio

Are you one of those investors scarred by the likes of Enron and WorldCom to the point where you now put little faith in a company’s reported net earnings? While the Sarbanes-Oxley Act of 2002 was passed to protect investors from possible fraudulent corporate accounting activities, it is impossible to eliminate them completely. Manipulation of numbers will most likely continue to exist in one form or another. The price-to-cash flow ratio (along with the price-to-sales ratio) can help alleviate some of these concerns.

Price-to-Cash Flow Ratio Defined

The price-to-cash flow ratio (or P/CF for short) is a measure used to compare a company's market value to its cash flow. The ratio is calculated in a similar manner to the ever-so-popular price-to-earnings ratio with one exception—price per share is divided by operating cash flow as opposed to earnings per share:

P/CF ratio = Price per Share/Operating Cash Flow per Share

Those that distrust net earnings look to this ratio mainly because cash flows are less subject to manipulation—actual cash is easy to keep track of and measure. Furthermore, some investors believe that cash is king—plain and simple. They are firm believers that the true health of a company is better measured by the cash it generates.

Operating cash flow can be found on a company’s cash flow statement and is defined as how much money the company received from its actual business operations (not from other sources such as investments). The figure is comprised of net earnings minus preferred dividends plus depreciation.

Digging into the Numbers

Just as the calculation of the P/CF ratio bears some resemblance to that of the P/E ratio, the same can be said of its interpretation. The higher the P/E ratio, the more highly valued a particular company is. Thus, the lower a stock's P/CF ratio, the better the value (the more undervalued).

Let’s say a company has a P/CF ratio of 18. This means that investors think every $1 in cash flow generated by the company is worth $18. At the time that this masterpiece was crafted, the P/CF ratio of the S&P 500, one of the most commonly used benchmarks for the overall U.S. stock market, stood at 14.

As with other financial barometers, P/CF ratios vary broadly from industry to industry. For example, when pen was put to paper for this article, the P/CF ratio of the computer software industry was 17.1. When looking at the airline industry, its ratio of 9.1 is quite different. Thus, when making comparisons, be sure to compare participants in the same industry. Otherwise what you may think is an undervalued stock may actually be quite the contrary when a comparison is made to its industry average.

Finally, an investor should never make a purchase decision based squarely on an attractive P/CF ratio. As we covered in our other ratio articles, investors should never use any single tool as a one-stop decision maker to uncover stocks that are potentially undervalued. It is highly recommended that a P/CF ratio be used in conjunction with other valuation metrics along with earnings estimate revisions and the Zacks Rank. (Learn more about the Zacks Rank).