For investors analyzing stocks, one of the most popular financial ratios is the price-to-earnings ratio (P/E). Using this financial ratio, investors can have 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 at an investor's disposal. Another financial ratio that's relatively overlooked is the "price-to-cash-flow ratio." Using this ratio as a part of your analysis can help identify undervalued stock opportunities.
Calculating the Price-to-Cash-Flow Ratio
The price-to-cash-flow ratio is a simple calculation. All you have to do is take the current share price and divide it by the total cash flow from operations found on the cash flow statement.
Some investors prefer to use a modified price-to-cash-flow ratio that 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.
The Difference Between Cash Flow and Earnings
To understand why the price-to-cash-flow ratio matters, it helps to revisit some accounting principles. The profit and loss statement (also known as a P&L or income statement) does not always line up perfectly with 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. It's also possible for a company's P&L to give the impression that the company has less cash on hand than it actually does.
Let's work through an example. You have $100,000 in cash from a trust fund to start a bakery business. You spend $80,000 on equipment, leaving $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 remaining value.
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 and $8,000 in depreciation expense (the equipment will lose $80,000 worth of value over 10 years, so 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 to account 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. However, a P/E ratio is calculated using the income statement's earnings, so 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, and investing guru Warren Buffett highlights them in his annual letter to shareholders. Rather, the price-to-cash-flow ratio simply provides an alternate way of analyzing a stock, which is best used in conjunction with other ratios.
The Price-to-Cash-Flow Ratio Works Better for Some Industries
Accounting practices make it more common for some types of businesses and industries to either understate or overstate their profits on the income statement. That's why it helps to know multiple valuation methods and compare ratios.
Take pharmaceutical companies, for example. These companies are required to spend massive amounts on research and development when it is developing drugs. One could make a compelling argument that those expenses should not be accounted for all at once, and 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 pharmaceutical company's profits can seem both deflated during research and development and inflated toward the end of a drug's lifespan.
In this scenario, the price-to-cash-flow ratio would provide a better idea of how much money management has to spend on further research and development, marketing support, debt reduction, dividends, share repurchases, and more.
For the best results, an analyst may choose to average several years of cash flow statements—perhaps as much as one full business cycle—to get an adjusted price-to-cash-flow ratio that factors in the entire development cycle of several drugs or products.
Another example of capital-intensive activities comes from the railroad industry. Investors can expect to see lower price-to-cash-flow ratios, compared to other industries, because railroads and associated equipment require expensive upkeep.
Software companies, on the other hand, come from 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, since it can be downloaded directly from cloud services or web browsers. Updating the software requires work, but not physical materials. A software designer simply needs a salary, and they'll spend the year updating the software.
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