The Price to Cash Flow ratio, also known as the P/CF, is a valuation metric employed to determine how much investors are willing to pay for each dollar of cash flow generated by the business. A company’s cash flow generation capacity is a strong indication of its profitability, therefore a business that has the ability to produce significant amounts of cash flow over time will probably be valued at a higher multiple than one that barely cover’s for its capital expenditures.
What is the Price to Cash Flow Ratio?
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The P/CF metric is employed by investors and analysts to determine how valuable the cash flow generation capacity of the firm is for the market. If the company has been able to consistently produce positive operating cash flow in the past, an analyst can rely on this to forecast the future price per share based on the cash flow pattern.
On the other hand, companies that show a reliable cash flow stream tend to be favored with a higher P/CF multiple, as investors understand the potential for growth that a steady stream of cash has if its reinvested in the business wisely. Nevertheless, the P/CF ratio doesn’t account for the company’s financial health, as the business may be full of debts and the cash flow could only be the by-product of leveraged investments. The profitability of these investments and the business capacity to fulfill its financial obligations should also be taken into account for valuation purposes.
Price to Cash Flow Ratio Formula
The formula to calculate the Price to Sales ratio is the following:
P/CF = Price per Share / Cash Flow per Share
Price Cash Flow Equation Components
Price per Share: The current market value of each of the company’s outstanding share.
Sales per Share: Operating cash flow divided by the number of outstanding shares.
This formula can be calculated at any given point in time for a company, yet, the cash flow figure employed for the Cash Flow per Share estimation should be carefully identified.
For example, if the analyst wants to compare the P/CF evolution on quarterly cash flow figures he should calculate the P/CF for quarterly cash flow figures for perhaps the last 12 quarters. If the analyst will compare this metric with those of similar companies, the calculation should also be done on a quarter-per-quarter basis for those companies.
As a result, the P/CF calculated for annual operating cash flow will always be lower than the P/CF calculated for quarterly cash flow figures. Yet, comparatively, both are valuable indicators as long as they are compared with other P/CF metrics estimated on the same time frames.
Also, a variation of the P/CF ratio is the P/FCF, which stands for Price to Free Cash Flow. This metric is also employed for valuation purposes, especially by value investors, who think that the business potential for growth is intimately associated with its capacity to generate Free Cash Flow.
Free Cash Flow is the result of deducting essential capital expenditures (CapEx) and changes in the working capital structure to the business’ net income plus its depreciation and amortization charges.
Price Cash Flow Example
Break Sports is a company that produces sports gear. The company is publicly traded and an investment banking firm is currently considering making a purchase of a significant percentage of shares in the company.
Break Sports financial information indicate that they currently have 16,430,000 shares outstanding and its operating cash flow for the last 5 years is the following:
- 2014: $68,000,000
- 2015: $72,000,000
- 2016: $55,000,000
- 2017: $88,000,000
- 2018: $85,000,000
Additionally, the price of the shares has closed each of these years as follows:
- 2014: $15
- 2015: $17
- 2016: $12
- 2017: $21
- 2018: $22
For each year the price of the P/CF metric will be calculated as stated in the formula above.
P/CF2014: $15 / $4.14 = 3.62
P/CF2015: $17 / $4.38 = 3.88
P/CF2016: $12 / $3.35 = 3.58
P/CF2017: $21 / $5.36 = 3.92
P/CF2018: $22 / $5.17 = 4.26
The average P/CF of Break Sports’ industry is 3. This means that the market values Break Sports at a higher multiple of its cash flow than its peers.
Price to Cash Flow Ratio Analysis
One of the ways the Price to Cash Flow ratio can be employed for valuation purposes involves forecasting the business’ cash flow for the next 5 years to estimate the value of the entire company, if the P/CF is consistent enough as to rely on it, as it is in the example above
Let’s say that Break Sports forecasted operating cash flow for 2019 is $92,000,000. Considering that the P/CF ratio has fluctuated between 3.60 and 4.20 in the last 5 years, an analyst can safely assume that the company’s price per share by then would be 4 times the cash flow per share.
According to this analysis, the price per share by 2019 will be between $20 and $23.50. This shows that this metric can be employed to quickly estimate the future value of a business by analyzing its past record. If a pattern can be identified on the Price to Cash Flow indicator that would be a valuable insight, as it will allow the analyst to make sound assumptions on the future behavior of share prices. On the other hand, if a pattern cannot be identified, the metric becomes useless for the purpose of analyzing or valuing the business.
In any case, a high Price to Cash Flow metric doesn’t really indicate something by itself. It must be compared to the P/CF of peer companies or even the industry average to draft a conclusion on it. Also, it should be accompanied by a Price to Earnings and a Price to Sales analysis, which can also be compared to other firms, to make sure there is enough information to make an informed decision on whether the shares are fairly priced.
Price to Cash Flow Uses, Cautions, Pitfalls
It is important to estimate the time series of the P/CF ratio for the company for past years to understand the behavior of this metric at other moments in time. The importance of doing this relies on the fact that a company with a volatile P/CF indicates that other elements besides cash flow are affecting its valuation.
On the other hand, a company with a consistent P/CF metric indicates that the market relies heavily on cash flow as one of the main drivers for the growth. Therefore, as cash flow grows, the value of the firm will also experience an increase.
Additionally, it is important to analyze the volatility in price before the formula is calculated. Knowing which price is the right one for the calculation, if the price has been volatile lately, can lead to misleading or distorted results based on short-term fluctuations. For this reason, the analyst should make sure the price he uses for the calculation accurately reflects the financial picture of the underlying business. In this sense, analyst commonly employed a 30 to 60 day average daily price instead of a single day’s price.