The price to cash flow ratio calculates the amount of cash flow generated by a business for every share outstanding. 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.
The price to cash flow ratio is calculated as follows:
Current share price / Cash flow per share = Price to cash flow ratio
For example, 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.
There are several issues to consider as part of this analysis. For instance, 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. As another example, a company is selling off its assets, which results in substantial cash flows. 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 these examples, investor expectations for future cash flows are driving the price of the stock, rather than the amount of current cash flows.