Price to cash flow ratio definition

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What is the Price to Cash Flow Ratio?

The price to cash flow ratio compares the stock price of a business to its operating cash flow per share. The ratio is used by investors to estimate the amount of cash flow that may be available for distribution to them as dividends, and also as a comparison to other potential investments. Shares that appear to be underpriced in relation to the cash flows being generated for other comparable companies could be a reasonable investment.

How to Calculate the Price to Cash Flow Ratio

The price to cash flow ratio is calculated by dividing the current share price by the cash flow per share. The formula is as follows:

Current share price ÷ Cash flow per share = Price to cash flow ratio

When to Use the Price to Cash Flow Ratio

This ratio is especially useful in cases where a company is recording substantial non-cash expenses, since these items will be stripped out of the cash flow information used in the ratio. The most common examples of non-cash expenses are depreciation expense and amortization expense.

Problems with the Price to Cash Flow Ratio

There are several problems with the price to cash flow ratio. These issues are as follows:

  • Outcome depends of growth. If a company is in high-growth mode and is rapidly gaining market share, then it may be burning through its cash and is experiencing negative cash flows. In this situation, investors will still give the firm’s stock a high valuation, since they expect the company to eventually generate significant cash flows.

  • Outcome depends on asset sales. A company could trigger substantial cash flows by selling off its assets. However, since investors realize that the asset base of the company is gradually being destroyed, they may be more likely to bid the share price down, despite the positive cash flows.

In both of the preceding examples, investor expectations for future cash flows are driving the price of the stock, rather than the amount of current cash flows.

  • Share price is as of a point in time. The ratio uses the stock price as of the date when the ratio is measured (usually the month-end share price). This price may differ significantly from the average stock price over the preceding period, due to general price variability. This issue can be corrected by using the average end-of-day stock price for all business days within the reporting period.

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Example of the Price to Cash Flow Ratio

The common stock of a business is currently being sold on a stock exchange for $10 per share. The company is generating cash flows of $3 per share, so the price to cash flow ratio is 3.33x. The industry average for this ratio is 2.75x, so the shares appear to be overpriced in relation to comparable companies.