Price multiples are often used to determine the value of a company's equity. The relative ease and simplicity of these relative valuation methods make them a favorite of institutional and private investors.
The price-to-earnings ratio, price-to-sales ratio and price-to-book ratio are often analyzed when comparing the prices of different securities based on a desired valuation criterion. The price-to-cash flow (P/CF) multiple falls into the same category as the previous pricing metrics, as it evaluates the price of a company's stock relative to the cash flow generated by the company.
P/CF multiples are calculated using a similar approach to the other price-based metrics. The P, or price, is simply the current price of the stock. To avoid the volatility of the multiple, a 30-day or 60-day average price can be used to provide a more stable value that is not distorted by random market movements. The CF or cash flow, which is in the denominator of the ratio, is obtained by calculating the cash flows generated by the company over the last 12 months divided by the number of shares outstanding.
There are several approaches to calculating cash flow. When benchmarking the relative values of similar companies, a consistent valuation approach should be applied throughout the valuation process.
Analyzing the value of a stock based on cash flow is similar to determining whether a stock is undervalued or overvalued based on earnings. A high P/CF ratio indicates that the company in question is trading at a high price but does not generate sufficient cash flows to support the multiple; sometimes this is fine, depending on the specific company, industry and activities. Smaller price ratios are generally preferred, as they can show that a company is generating ample cash flows that are not yet adequately reflected in the current stock price.
Holding all factors constant, from an investment standpoint, a lower P/CF is preferable to a higher multiple. However, as with all fundamental ratios, a ratio never tells the whole story. To assess the intrinsic value of an investment, one must determine the big picture from multiple angles (ratios). The P/CF multiple is simply another tool investors should add to their repertoire of value discovery techniques.
