“Cash is King” say the bigwigs on Wall Street. That is why the
valuation of shares is done on the basis of discounted cash flow model
rather than discounted earnings model. The price to cash flow ratio
provides an analyst with a shortcut for finding companies that have been
undervalued in comparison to their cash flows. Analysts can scan
through the price to cash flow ratios of a number of companies. Then
they can start paying more attention to the companies where these values
seem to be abnormally low. This article describes price to cash flow
ratio is more detail.
Formula
There are many different measures of what analysts consider to be the
true cash flow of the company. Some analysts consider operating cash
flow i.e. cash flow generated from regular activities to be the correct
measure. Others think that the capital investments that the company
needs to make must be separated and the resultant free cash flow
provides a better picture of the company’s fundamentals. Accordingly
there are at least two cash flow measures that an analyst can look at
and here are their formulas:
Price to Operating Cash Flow = Current Market Price / Operating Cash Flow
Price to Free Cash Flow = Current Market Price / Free Cash Flow
Meaning
The price to cash flow ratio tells the investor the number of rupees
that they are paying for every rupee in cash flow that the company
earns. Thus if the price to cash flow ratio is 3, then the investors are
paying 3 rupees for a stream of future cash flows of 1 rupee each. This
cash flow is passed on to the investors as dividend. In case, it is
reinvested in the business, it shows up as capital appreciation. Thus
cash flow will help the investors gain in one way or another.
Interpretation
- Cannot be Manipulated: The price to cash flow ratio is considered to be a more stringent measure by many. The basic reason being that cash flow cannot be manipulated. Cash in the bank is a fact unlike earnings which are the management’s opinion. Charges like depreciation, changes in inventory and revenue policy do not affect the cash position making it the favorite of skeptics.
- No Effect of Compounding: The price to cash flow ratio does not consider the effect of compounding. Once cash is received it can be immediately put to work to earn even more cash. However, the ratio fails to capture this phenomenon.
