One of the most popular financial ratios is the price-to-earnings ratio (P/E). It can help give investors a better idea of how the value of one stock compares to the value of another.
Despite its popularity, P/E is just one tool. Another financial ratio that's often overlooked is the price-to-cash-flow ratio. Using it may help you find undervalued stock opportunities.
- The price-to-cash-flow ratio takes the current share price and divides it by the total cash flow from operations.
- Some prefer to use a modified price-to-cash-flow ratio. This uses free cash flow instead of total cash flow from operations.
- The profit and loss statement does not always line up with the cash flow statement.
- Some businesses and industries either understate or overstate their profits on the income statement.
How Do You Find the Price-to-Cash-Flow Ratio?
The price-to-cash-flow ratio is simple to find. All you have to do is take the current share price; then, divide it by the total cash flow from operations found on the cash flow statement.
Some prefer to use a modified price-to-cash-flow ratio. This uses free cash flow instead of total cash flow from operations. Free cash flow adjusts for expenses such as amortization and depreciation, changes in working capital, and capital expenditures.
What Is the Difference Between Cash Flow and Earnings?
Why does the price-to-cash-flow ratio matter? It helps to look at some accounting principles. The profit and loss statement does not always line up perfectly with the cash flow statement. That means that it's possible for a company to report huge profits...and at the same time, it may not be able to pay its bills. The reverse can also be true.
The profit and loss statement may also be known as a P&L or income statement.
Here's an example. Let's say you have $100,000 in cash from a trust fund to start a business. You spend $80,000 on equipment. That leaves $20,000 in cash for working capital. You expect the equipment to last for 10 years. At the end of those 10 years, the equipment will have no value.
The balance sheet would show $80,000 in property, plant, and equipment costs and $20,000 in cash. It would show nothing else. At the end of the year, if you had no sales, your income statement would show $0 in revenue and $8,000 in depreciation expense. (The equipment will lose $80,000 worth of value over 10 years. This figure annualizes that depreciation.)
All told, the balance sheet would calculate a pre-tax operating loss of $8,000.
Thus, the balance sheet at the end of year one would be $20,000 cash; $80,000 property, plant, and equipment costs; and retained earnings of -$8,000. For the next 10 years, you would continue to mark -$8,000 on your balance sheet. This accounts for the depreciating value of the equipment.
That doesn't capture the full reality of the situation. You aren't spending $8,000 in cash every year. You spent all that cash upfront in the first year. But P/E ratio is calculated using the income statement's earnings. That means it includes depreciation expenses.
In reality, this company would have $8,000 more in cash than its P&L states. A cash flow statement would reflect this discrepancy. That's not to say that depreciation expenses aren't worth paying attention to. They certainly are. Famously, Warren Buffett would highlight them in his annual letter to shareholders.
The price-to-cash-flow ratio simply provides an alternate way of analyzing a stock. It's best used in conjunction with other ratios.
Where Does Price-to-Cash-Flow Ratio Work Best?
It's common for some types of businesses or industries to understate or overstate their profits on the P&L. That's why it helps to know multiple ratios.
Take pharmaceutical companies, for instance. They spend massive amounts on research and development; this is needed to develop drugs. Some may think these expenses should not be accounted for all at once; the costs should instead be spread out over the years that the drug is sold.
By accounting for the entire expense as it incurs, a pharma company's profits can seem deflated during R&D. And they can seem inflated toward the end of a drug's lifespan.
In this case, the price-to-cash-flow ratio would provide a better idea of how much money can be spent. It may be used for further R&D, marketing support, debt reduction, dividends, share repurchases, and more.
For the best results, you may choose to average several years of cash flow statements. In fact, you may want to look at one full business cycle. This can help you get an adjusted price-to-cash-flow ratio. And it can factor in the entire development cycle of products.
Railroads are also capital-intensive. You can expect to see lower price-to-cash-flow ratios compared to other industries. That's because railroads require expensive upkeep.
Software companies are another story. This is an industry where it's common to see much higher price-to-cash-flow ratios. They have very low capital requirements. Once the product has been developed, it costs almost nothing to distribute it. That's because it can be downloaded directly from cloud services or web browsers. Updating the software requires work. But it doesn't need physical materials. A software designer simply needs a salary. They'll spend the year updating the software.