The Price to Cash Flow ratio (P/CF) is a profitability ratio that compares the price of a company to the underlying cash flow. It is a valuation metric, which indicates the worth of the company based on the cash flow generated by it. In other words, it shows the dollar value an investor is willing to pay for the cash flow generated by the firm. Investors and analysts typically use this ratio to describe the valuation of a company with respect to one of the most important consideration in a company’s?balance sheet: cash.

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Accounting statements are filled with creative adjustments to non-cash items. These items tend to blur the clarity of the underlying profitability of a firm. This is where the?cash flow statement?comes in useful. It adjusts for all non-cash items and provides a picture of the underlying cash generated by a business. Thus, the P/CF ratio compares the cash flow of the business to its market value in an effort to demonstrate if the valuation is justified or not.

Generally, a low P/CF indicates an undervaluation of a firm’s potential. However, like any valuation ratio, P/CF needs to be analyzed compared to the historical, industry (sector), and market point of view. Of all these factors, we can argue that ‘investor expectation’ is the most important parameters, because it normally encompasses the previous two parameters and future expectations.

Let’s look at how to calculate the price to cash flow ratio.

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The Price to Cash Flow ratio formula is calculated by dividing the share price by the operating cash flow per share:

Price to Cash Flow = Share Price (or Market Cap) / Operating Cash Flow per share (or Operating Cash Flow)

The P/CF ratio equation can also be calculated using the market cap like this:

Operating cash flow is mentioned in the cash flow statement of the annual report. The number of?shares outstanding?is typically listed in the?income statement?and the annual report.

Operating Cash Flow can be calculated using the following formula:

OCF = Net Income + Depreciation + Amortization + Change in WC + Any other non-cash item

Share Price or Market Cap is price that a share of stock is traded at on the open market. Due to this factor, every valuation metrics (such as P/CF) needs to be time stamped.

Let’s calculate and analyze a few examples to understand the concept better.

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The table below is Company A’s numbers taken from their year-end financial statements and reports. We can see that in the year 2 and 3, the OCF has increased from 7 to 9, but P/CF has remained at 1.7x. This is because the share has increased by similar proportion during the same period, keeping the valuation unchanged.

This means that Company A investors are willing to pay $2 for every dollar of cash flows in year 1. In year 3, however, investors aren’t will to pay $2 anymore. Now they are only willing to pay a multiple of 1.7 for the cash flows of the business. Thus, they will only pay $1.70 for every dollar of cash flows.

Let us consider two real world examples of Steel companies: ArcelorMittal & ThyssenKrupp. We have computed the P/CF ratio for both of these companies and presented our findings in the table below. We have used year-end share price for calculation. The ratio can be calculated at current share price to get a different perspective of the numbers. While most of their business is comparable (steel production), it is worth noting that ThyssenKrupp also has few other business lines, which might impact the multiples.

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P/CF is one of the most used multiples in the investment industry. Analysts often need to know the valuation of a company with respect to the cash it generates from the underlying operations. Cash flows analysis with respect to price also helps us compare different companies in the same industry irrespective of certain accounting differences.

In the example of the steel companies presented above, we see that ArcelorMittal has a large P/CF compared to ThyssenKrupp. Intuitively, it might mean that the Arcelor is costlier than Thyssen. While, that might be the case, an analyst needs to look at it from an overall business point of view. It is possible that the cash flows of Arcelor have been very weak while the share price has not corrected to the same extent. On the other hand, investors might pay a premium for the company given it is one of the largest steel producers in the world, so they expect strong turnaround in the company. Again, if the excitement is unfounded, it is advisable to stay away from such companies. Valuation is also dependent on perception and risk appetite of investors.

Analysts should always compare the multiple against the market expectations. They should also explore the drivers of a ratio. Detailed financial analysis is required to determine if the management is not doing any creative business practices to boost cash flows for a short period, at the expense of long-term value erosion.

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Analysts need to be careful about which cash flow numbers they use and make sure they keep it consistent while doing a peer analysis.?Operating cash flow?and?free cash flow?are the most commonly used multiples. However it is important to understand how each company reports these numbers and perform a like-for-like analysis.

Analysts need to also ensure that the management is not doing any fancy adjustments to boost short-term cash position (especially, if their incentives are linked to these numbers).

P/CF is a powerful tool to value companies that have positive cash flow but might be having negative cash earnings due to large non-cash items. On the other hand, this ratio becomes useless in the case a company is not generating positive cash flows. Hence, P/CF should be analyzed in parallel with valuation rations such as the?PE Ratio?and?Dividend Yield. It can also be used with absolute valuation metrics like Discounted Cash Flow – which provides the absolute value of a company based on future expectation.

In conclusion, P/CF is a very useful valuation tool to compare the cash profitability to market value of a company, but it should be used while considering its limitations and biases.