Why Using Cash Flow Is Better Than P/E
How to Calculate Cash Flow When Valuing Stocks
Many investors believe that cash flow ratios are a better measurement of a stock’s value than Price Earnings Ratio or P/E. Why? Because the amount of cash a company is capable of generating is one of the more important measures of its health. You'll probably hear more about P/E than almost any other metric on valuation, but it can't really give you an accurate picture of a company’s ability to generate cash, which is ultimately the bottom line.
What Is P/E?
P/E represents the ratio of a stock’s price to its Earnings Per Share, referred to as EPS. It's an important metric if for no other reason than many people think it is. When a company’s P/E is very high or low, it gets top billing on the news. It snags a lot of attention.
Metrics that examine a company’s price relative to its cash position are equally important, but they're overlooked by many. In fact, they might even be more important.
The Importance of Cash
The reality is that without cash, a company won’t last long. That might seem obviously simple, but many, many companies have failed simply because cash is in too short supply. So how do you use cash flow ratios to see if a company is under- or over-valued, which is the same purpose of P/E? Two primary measurements shed light on a company’s valuation.
Price to Cash Flow
Price to cash flow is determined by dividing the stock’s price by cash flow per share. Many prefer this measurement because it uses cash flow rather than net income the way computing EPS does.
Cash flow is a company’s net income with the depreciation and amortization charges added back in. These charges reduce net income, but they don't represent actual outlays of cash so they artificially reduce the company’s reported cash. Because these expenses don’t involve actual cash, the company has more cash than the net income figure indicates.
Free Cash Flow
Free cash flow is a refinement of cash flow that goes a step further and adds in one-time expense capital expenses, dividend payments, and other non-occurring charges back to cash flow. The result is how much cash the company generated in the previous 12 months. Divide the current price by the free cash flow per share and the result describes the value the market places on the company’s ability to generate cash.
Undervalued and Overvalued Stock
Like the P/E, both these cash flow ratios suggest where the market values the company. Lower numbers relative to a company's industry and sector suggest that the market has undervalued its stock. Higher numbers than its industry and sector might mean that the market has overvalued the stock.
Thankfully, you don’t have to do all these calculations yourself. Many websites include these valuation numbers for your consideration, including Reuters.com. Their detailed quotes offer both cash flow ratios. Just enter a stock in the quote box on the top bar if you use Reuters, then click on “Ratios” in the left column links.
Like all ratios, these don’t tell the whole story. Be sure to look at other metrics to verify relative value. But these cash flow ratios can give you some significant clues as to how a company is performing and to how the market values its stock as a whole.