What is a Price-to-Cash Flow Ratio (P/CF)?
The price-to-cash flow ratio (P/CF) is used to evaluate the price of a company's stock as compared to the amount of cash flow it generates.
How Does a Price-to-Cash Flow Ratio (P/CF) Work?
The formula for the price-to-cash flow ratio is:
Price-to-Cash Flow Ratio = Price per share / (Cash flow / Shares outstanding)
For example, let's assume that Company XYZ has a share price of $3 and has 10,000,000 shares outstanding. In 2010, Company XYZ generated $5,000,000 of cash flow. Using the formula above, we can calculate Company XYZ's P/CF ratio as:
Price to Cash Flow = $3 / ($5,000,000 / 10,000,000) = 6.0
Many analysts recommend using fully diluted shares outstanding when calculating this ratio.
Why Does a Price-to-Cash Flow Ratio (P/CF) Matter?
The price-to-cash flow ratio offers investors a somewhat more useful look at a company's value than the P/E ratio, because the price-to-cash flow ratio uses a denominator that excludes the effects of depreciation and the accounting differences related to depreciation. It turns the attention to how much cash a company generates relative to its stock price rather than what it records in earnings relative to stock price.
However, the price-to-cash flow ratio is usually more insightful for companies within the same industry, because capital intensity (and thus depreciation) can vary widely among industries. For example, companies with lower price-to-cash flow ratios tend to be more capital-intensive. Thus, the definition of a 'high' or 'low' ratio should be made within this context.