Some investors prefer to focus on a financial ratio known as the price-to-cash-flow ratio instead of the more used price-to-earnings ratio (or p/e ratio for short). Sit back, relax, and grab a cup of coffee because you're about to learn everything you ever wanted to know about this often overlooked stock valuation tool.
The Difference Between Cash Flow and Earnings
To understand why the price-to-cash-flow ratio matters, you have to understand some accounting. The profit and loss statement (or income statement as it is more commonly known) does not always equal the cash flow statement. It's theoretically possible for a company to report huge profits and be unable to pay its bills due to liquidity problems.
Imagine you own a bakery. You have $100,000 in cash to start your business from an inheritance; perhaps your parents or grandparents set up a trust fund. You buy equipment worth $80,000, leaving $20,000 in cash for working capital. You expect the equipment to last for 10 years and have no value when it's reached the end of that period.
Immediately, the balance sheet would show $80,000 in property, plant, and equipment costs, $20,000 in cash, and nothing else. At the end of the year, if you had no sales, your income statement would show $0 in revenue, $8,000 in depreciation expense ($80,000 cost - $0 salvage value divided by 10 years = $8,000 annual depreciation) for 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 (offset by $8,000 in accumulated depreciation so that the balance sheet shows a net depreciation balance of $72,000) and retained earnings of -$8,000. Each year, you would write off an additional $8,000 until the value of the equipment on the balance sheet had been reduced to $0.
The reality of the situation is much different. You aren't losing $8,000 per year. Instead, in the first year, you spent $80,000 and you only have $20,000 in the bank. The result is that you actually have $8,000 more in cash each year than the profit and loss statement would indicate.
Once you began to generate profit, the price-to-earnings ratio would understate the amount of money you had available in subsequent years to put to work in expansion, whereas the price to cash flow ratio would more accurately describe the situation. That's not to say that the depreciation expense isn't real; it certainly is, as Warren Buffett reminds us that the tooth fairy doesn't pay for capital expenditures!
The Price-to-Cash-Flow Ratio is Better for Some Industries
The accounting rules sometimes cause certain types of businesses or industries to understate or overstate their true profits, causing the price to cash flow ratio to work better for valuation purposes than its counterpart, the price to earnings ratio.
Take a pharmaceutical company, which is required to expense massive amounts of research and development when it is developing drugs. One could make a compelling argument that those expenses should not be taken all at once but instead spread out of the period when a drug is sold because it is equivalent to buying equipment for your bakery.
Yet, the current rules require that much of the cost be written off as an expense when it is incurred, meaning that early years in a product development tend to show very low profits, or in some cases even massive losses, with inflated profits toward the end.
When examining a potential investment, this is no small matter. The price-to-earnings ratio of a drug company is going to be less useful than the price to cash flow ratio as a result of these accounting rules.
That's why you often hear Wall Street analysts talking about the life cycle of drug patents. They make adjustments for drugs that have been in development, drugs that will soon be subject to generic competition, and other factors so that they can estimate the funds available to stockholders during any given fiscal year.
Thus, the price to earnings ratio is simply not useful in such a situation. The price to cash flow ratio would provide a better idea of the amount of money available to management for further research and development, marketing support, debt reduction, dividends, share repurchases, and more.
For the best results, a good analyst would most likely average several years, perhaps as much as one full business cycle, of cash flow statements to get an adjusted price to cash flow ratio that factored in the entire development cycle of several drugs or products.
Calculating the Price to Cash Flow Ratio
The price to cash flow ratio is calculated by taking the current share price and dividing the total cash flow from operations found on the cash flow statement. Some investors prefer to use a modified price-to-cash flow ratio based on something known as free cash flow. It adjusts for expenses such as amortization and depreciation, changes in working capital, and capital expenditures.
Using the Price-to-Cash-Flow Ratio to Value Stocks
The average price to cash flow ratio varies from industry to industry. For companies involved in capital-intensive activities, such as the auto companies and railroads, you are going to see much lower price to cash flow multiples because investors know that much of the money is going to have to be poured back into equipment, facilities, materials, and fixed assets or else the firm will be hurt. Imagine, for instance, if a car company stopped updating its factories. At some point, the cars simply can't be made!
Industries such as software, on the other hand, allow for much higher price-to-cash-flow ratios because they have very low capital requirements. Once the product has been developed, the only real cost is a cheap piece of plastic (the DVD or CD) to put the program on and the cardboard for the box.