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Understanding the Price to Cash Flow Ratio and Its Uses

The price to earnings (P/E) ratio, which is the price of a company’s stock divided by its earnings per share, is probably the most common ratio used by investors as a quick way to determine a company’s value. In general, the lower the ratio is, the better it could be.

But, there is an alternative to the P/E ratio, namely, the price to cash flow (P/CF) ratio.

Behind the scenes of the P/CF ratio

The formula for the P/CF ratio is shown below:

P/CF = (Share price of a company) / (Operating cash flow per share)

The share price of a company is easily obtained online, so the key here is the cash flow per share figure. It can be derived by taking a company’s operating cash flow and dividing it by the number of shares outstanding.

Let’s look at a simple illustration. Assume Company ABC has 100 million shares outstanding, which are trading at $3 each. ABC also recorded $15 million in operating cash flow over the last 12 months. Using the formula above, we can calculate Company ABC’s P/CF ratio as follows:

P/CF = $3 / ($15,000,000/100,000,000) = 20

The uses of the P/CF ratio

The P/E ratio uses a company’s earnings per share, which is in turn derived from net income. But net income, in comparison to operating cash flow, can be more easily manipulated. A company can also report huge net income, but actually have little capital to grow the business or withstand unexpected shocks.

In a similar manner to the P/E ratio, a low P/CF ratio is generally preferred over a high one. A high P/CF ratio may be a hint that the company in question is trading at a high price but is not generating enough cash flows to support that valuation.

It’s worth noting that one metric is never able to tell the full story with a company. So, it’s important to study other aspects of a company beyond its P/CF ratio. Consider the P/CF ratio as another tool that you can use to evaluate a company’s value.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.