The Price-to-Cash ratio explained.

The price-to-cash flow ratio is a “valuation metric” that measures a company’s stock price value relative to its per-share operating cash flow (the amount of cash it produces). The P/CF is a handy tool as it considers a company’s ability to generate cash flow from its operations while removing the impact of non-cash expenses such as depreciation and amortisation. This helps the ratio be more reliable as it minimises the exposure to manipulated accounting practices from earnings reported.

Cash flow is one of the key areas I look at when valuing companies. Earnings and profits are important but positive cash flow allows a company to reinvest and compound over the long haul. The price-to-cash-flow allows investors to value a business with positive cash flow that is not yet profitable due to large non-cash items distorting a company’s financial picture.

P/CF quality depends on the business fundamentals, industry, and business cycle. Low often indicates undervaluation and high reflects overvaluation. It is however always relative to the underlying business to whether it is “good” or “bad”.

There are some limitations to using the P/CF such as not considering debt, capital expenditures, and other liabilities that will not be reflected in the operating cash flow model. The P/CF is valuable in circumstances where there is a large divergence between earnings and cash flow.

The price-to-earnings ratio represents the amount that investors are currently willing to pay for every dollar of net income generated, whereas the P/CF represents the amount investors are willing to pay for every dollar of cash generated.

A company’s cash flow and earnings are closely related and should follow each other closely. Differences can arise from non-cash earnings, reinvesting to grow, and paying dividends. If earnings go up but cash flow goes down, investigate why there is a disparity. Fast-growing companies may use cash for expansion, which can be good or bad depending on the investment opportunities.

What is the Price-to-Cash flow formula?

• P/CF = Market Cap ÷ Operating Cash Flow
• Operating Free Cashflow = Found on the Cash Flow Statement

*The Price-to-Cash Flow ratio can also be calculated on a per-share basis. Simply find the Shares outstanding, and the current share price divide the OCF by the Shares Outstanding and then divide the Share Price by the OCF Per Share.

What is Operating Cash Flow? Operating cash flow can be found in the cash flow statement, which shows the inflow and outflow of cash in a business. Operating cash flow tells investors whether a company has enough cash flow to keep the lights on and cover its cost of operating.

Operating Cash Flow = Net Income + Depreciation + Amoritisation + Change in Working Capital + Non-Cash Items

How to use the Price-to-Cash flow ratio?

When using the P/CF it is important to compare the business to others in the same industry and at similar cap sizes. An early-stage business will have a very different multiple than a mature business even in the same industry. Let’s compare 3 companies in the same industry that have an industry benchmark of 15.

P/CF	Company A	Company B	Company C
Market Cap	$1.5 billion	$750 million	$1.9 billion
Operating Cash Flow	$275 million	$45 million	$161 million
Price-to-Cash Flow	5.45	16.66	11.80

Company A $1.5b ÷ $175m = 5.45

Company B $750m ÷ $45m = 16.66

Company C $1.9b ÷ $161m = 11.8

So, what does this tell us? The multiple of 5.45 means investors are willing to pay $5.45 for every dollar of cash flow (the company’s market value is 5.45 times its cash flow). A low P/CF indicates that the stock is trading at a discount to the company’s operating cash flow and the opposite is true of a higher P/CF.

If we investigate the company further and find the underlying business of Company A is strong and undervalued compared to the industry and its peers, then it could be a good value play.

However, if we find that a company has a high P/CF although it may be considered overvalued sometimes it may be okay if the company has a long runway of growth ahead and the business fundamentals are strong enough to support that valuation.

Another example below looks at two companies with similar fundamentals and the same P/E ratio to show how the P/CF can come into play in identifying better investment opportunities when everything else is quite similiar.

	Company A	Company B
Closing Share Price	$11.75	$9.42
Shares Outstanding	100 million	128 mil
Market Cap	$1.175 billion	$1.20 billion
Operating Income	$75 million	$60 million
(+) Depreciation	$5 million	$6 million
(+) Amoritisation	$10 million	$7 million
(-) Change in WC	($12) million	($10) million
Operating Cash	$78 million	$63 million
Price-to-Earnings	15.66	15.7
OCF per Share	0.78 Cents	0.49 Cents
Price-to-Cash Flow	15.06	19.04

In this overly simplified example, we value two companies with a similar market cap and P/E ratio. With slightly different numbers in the cashflow, we can see that Company A presents better value as investors are willing to pay only $15.06 for every dollar of cash flow generated. Company B is slightly more expensive than Company A.

This is a great example of how we can look past the earnings and other multiples and value a business on its raw operating cash flow. The company with a lower multiple and higher cash flow is the winner in this peer-to-peer comparison. The difference is caused by the non-cash add-back of areas like D&A.

Taking this one step further in our analysis we can also take Company A and look back over the past few years to see how its Cash Flow and P/CF have evolved over time. Is it declining or increasing? If it is increasing it could mean the company is not generating enough cash to support the new valuation.

In Summary…

Investment styles differ in their preference for P/CF multiples. Value investors aim for lower P/CF as it signifies undervaluation, while growth investors may accept higher P/CF for a high-growth business with minimal cash flow.

A low P/CF ratio suggests a company is generating cash for reinvesting in growth opportunities, dividends or buybacks. A high P/CF ratio may indicate insufficient cash, leading to a decline in stock value.

I typically adjust my ratio and low/high multiples based on what I am searching for or what opportunities arise. In early-stage or hyper-growth company analysis I will rarely ever use the P/CF and instead use the price-to-sales ratio.

Invert the approach to using this multiple. After you have done your fundamental analysis and research, ask yourself do you want to pay that share price for every dollar of cash flow? Does this investment warrant this multiple in the future?