Sunday, September 18, 2011

Price to Cash Flow Ratio vs. Free Cash Flow

Many financial experts claim that cash flow gives a more accurate measurement for the value of a stock than the price to earnings ratio (P/E).

The viability of a company can be best measured in terms of how much money it can make with its available resources. However, the most often used term for evaluating a company is the P/E, which yet fails to give an accurate presentation of the company's potential to earn money for its shareholders.

P/E Definition

P/E (price to earnings) represents a ratio that depicts the stock's price relative to its earnings per share (EPS). The value of the P/E is important especially when it reaches its upper or lower extremes.

However, the importance of ratios that depict company's price relative to its cash should not be underestimated. This is so since if a company has no cash at all its existence is under question.

The history is full of examples of companies that did not have enough money to cover their activities and as a result went bankrupt.

In the light of the importance of cash availability we want to suggest you several ratios that include cash as their component. These ratios will help you determine whether a particular company is over-valued or under-valued

Price to Cash Flow Ratio

The formula for calculating the price to cash flow ratio is as follows:

Price to Cash Flow = Stock's Price / Cash Flow per Share

As you can see, the formula includes cash flow instead of net income. This is preferred by many financial experts since in the cash flow of the company depreciation and amortization are added back. Since amortization and depreciation don't represent an expense that deprives the company of money, the reported cash of the company is artificially reduced.

These expenditures are characterized by the fact that they don't involve actual cash. As a result the net income presents a number that is less than the actual cash the company has.

Free Cash Flow Formula

The free cash flow represents an extension of the cash flow. It further includes:
  • One-time expenses
  • Capital expenses
  • Dividend payments
  • Other non-occurring charges
When you add these numbers to the cash flow you get the cash the company makes in the trailing twelve months.

In order to see how the market valuates the ability of the company to make cash you should divide the current price of the company's stock by the free cash flow per share.

Free Cash Flow Formula vs. Price to Cash Flow Ratio

Both of these methods present a useful way to find out the valuation the market assigns to the stocks of a particular company. Depending on the results of the calculations you can determine whether the market has overvalued or undervalued the company.

For example, if the result is a higher number than the numbers of the other companies from the same industry, then it is reasonable to conclude that the market has overvalued the company.

On the other hand, if the result is a lower number as compared to those of the other companies from the same industry, then it is reasonable to conclude that the market has undervalued the company.
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