What it means
The price-to-earnings ratio divides the share price by earnings per share. Earnings, however, are an accounting construct shaped by depreciation and amortization schedules, provisions, revenue recognition judgements and one-off items.
Two companies with identical cash generation can report very different earnings if one depreciates its assets faster or has just written down goodwill. The price-to-cash flow ratio strips out those differences by using operating cash flow, the cash actually produced by running the business before investment and financing.
A low ratio suggests investors are paying little for each dollar of cash flow, which may mean the shares are undervalued or that the market expects cash flow to decline. A high ratio suggests investors expect strong growth or that the shares are expensive.
As with all valuation multiples, the figure means little in isolation and should be compared with the company's own history, with peers in the same industry and with the growth the company is delivering. Which cash flow to use matters.
Operating cash flow is the standard numerator and is taken from the cash flow statement. Some analysts prefer free cash flow (operating cash flow minus capital expenditure), which gives the price-to-free-cash-flow ratio; it is stricter, because it deducts the reinvestment needed to keep the business going, and it is the better measure for businesses with heavy ongoing capital needs.
Both are usually calculated on a trailing twelve-month basis, though forward estimates are also used. The ratio has weaknesses of its own.
Operating cash flow can swing with working capital movements: a company that collects a large receivable or delays paying suppliers will show a one-off boost. It also ignores capital expenditure, which for an asset-heavy business can consume most of the operating cash flow.
Reading price-to-cash flow alongside price-to-free-cash flow and the price-to-earnings ratio, rather than instead of them, gives the fullest picture.
In practice
Real-world examples.
Example
A shipping company reports a net loss after large depreciation charges on its fleet but generates strong operating cash flow; its price-to-earnings ratio is meaningless while its price-to-cash flow of 5 shows the shares are cheap relative to cash generation.
Example
An investor screens a stock market for companies with a price-to-free cash flow below 12 and free cash flow growing for three years, and builds a watch list from the results.
Example
A utility trades on a price-to-cash flow of 6 but a price-to-free cash flow of 25 because regulatory obligations require it to spend most of its cash flow on infrastructure.
Think of it
“Price-to-cash flow shows what you pay for each dollar of actual cash the company generates from operations.
Formula
Calculation
Price-to-Cash Flow Ratio = Share Price / Operating Cash Flow per Share
or equivalently: Market Capitalization / Operating Cash Flow
Price-to-Free Cash Flow Ratio = Market Capitalization / (Operating Cash Flow minus Capital Expenditure)
Worked example. A telecommunications company has 500 million shares trading at $32. Its cash flow statement shows operating cash flow of $2,000 million and capital expenditure of $1,200 million. Its net profit was $800 million.
- Market cap = 500,000,000 x $32 = $16,000 million
- Operating cash flow per share = $2,000 million / 500 million = $4.00
- Price-to-cash flow = $32 / $4.00 = 8.0 (or $16,000 million / $2,000 million = 8.0)
- Free cash flow = $2,000 million minus $1,200 million = $800 million
- Price-to-free cash flow = $16,000 million / $800 million = 20.0
- Earnings per share = $800 million / 500 million = $1.60; price-to-earnings = $32 / $1.60 = 20.0
The price-to-cash flow of 8 looks cheap, but the business must reinvest 60% of its operating cash flow just to maintain its network, so the price-to-free cash flow of 20 is the more honest measure and matches the price-to-earnings ratio.
Comparison: a software company with the same $16,000 million market cap has operating cash flow of $1,000 million and capital expenditure of $50 million. Its price-to-cash flow is 16 and its price-to-free cash flow is 16.8. On operating cash flow alone the telecom looks half the price; on free cash flow they are close.Case study
Seen in the real world.
A value fund manager found a printing and packaging company trading at a price-to-cash flow ratio of 4.5, a third of the sector average, and bought a large position. Operating cash flow had indeed been strong for three years. What the manager had not weighed was the cash flow statement's investing section: the company had cut capital expenditure to 30% of depreciation to fund its dividend, and its presses were ageing.
Within a year, breakdowns forced an emergency $90 million investment programme, free cash flow turned negative, the dividend was suspended and the shares halved. The price-to-free cash flow ratio, which had been 40 at the time of purchase, had been telling the truth all along. The manager's post-mortem changed the fund's screening rule: price-to-cash flow is used only in combination with price-to-free cash flow, and any company whose capital expenditure runs below depreciation for more than two years is flagged.
Watch out
Common mistakes.
- Using operating cash flow for capital-intensive businesses without also looking at free cash flow. The reinvestment needed to stay in business is a real cost.
- Reading a single year's operating cash flow without checking for one-off working capital movements that inflate or depress it.
- Comparing the ratio across industries with very different capital needs. Compare with peers and with the company's own history.
Questions
People also ask.
What is a good price-to-cash flow ratio?
Historically, ratios below 10 have often been considered attractive and above 20 expensive, but the right level depends on growth, industry and interest rates.
Why use cash flow instead of earnings?
Cash flow is less affected by accounting choices such as depreciation policy, provisions and non-cash write-downs, so it can reveal value that earnings obscure, or the reverse.
Is price-to-cash flow better than price-to-earnings?
Neither is better alone. Together, with price-to-free cash flow, they show whether earnings are backed by cash and whether cash is being consumed by reinvestment.
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