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.

For more insights on investing and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

Like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.

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