Key to making money with shares. Lesson 7. P/CF Ratio as exemplified by Facebook

Today, we are going to discuss another crucial indicator which is the price-to-cash flow ratio.

Price-to-cash flow ratio: Definition

Price-to-cash flow ratio (P/CF) is an indicator that compares a company's market value to its operating cash flow (or the value of the stock price relative to operating cash flow per share).

In essence, P/CF measures the current price of the company's stock relative to how much cash flow it generates. This metric is used primarily in the benchmarking analysis.

Calculation Formula

By definition, there are two ways to calculate P/CF. In the first instance, we use the company’s market cap (capitalization). The price-to-cash flow formula in this case looks as follows:

In the second instance, the ratio can be determined using the cash flow per share. Thus, price-to-cash will be calculated based on the formula shown below:

Examples

To gain a better insight into P/CF and how it works, we shall examine several illustrative examples.

So, the Operating Cash Flow per Share formula looks as follows:

Operating Cash Flow Per Share = Operating Cash Flow / Shares Outstanding (Average Diluted).

We need two figures for this calculation:

1. Operating Cash Flow which can be found in the cash flow statement.
2. The amount of Shares Outstanding.

Training Example 1

Here’s what we know:

Stock Price — 60;
CF per share — 12.

P/CF = 60 / 12 = 5

Training Example 2

Here’s what we know:

Stock Price — 60;
CF — 1,200;
Shares Outstanding — 300.

CF per Share = 1200 / 300 = 4

P/CF = 60 / 4 = 15

Hands-on case. Facebook

1. Let’s take a closer look at the example demonstrating the calculation of the cash flow from operation based on data derived from the latest Facebook statements. Cash flow from operation (as of September 2020):

Net Income from Continuing Operating Activities $7,846 billion + Depreciation $1,698 billion + Changes in Current Assets $61 million − Deferred Tax $1,506 billion + Cash Flow from Discontinued Operations + Share-Based Compensation $1,722 billion + Cash Flow from Other $7 million = $9,828 billion

2. We shall calculate it by applying the trailing 12 months (TTM). With that in mind, we use data for December 2019, March and April 2020.

Thus, Facebook’s Cash Flow from Operating Activities for trailing 12 months (TTM) — for the period ended in September 2020:

$9,083 (Dec 2019) + $11,001 (Mar 2020) + $3,877 (Jun 2020) + $9,829 (Sep 2020) = $33,790

3. Now let’s calculate the P/CF ratio using two formulas. The stock price as of November 4, 2020 is $287.38.

Price-to-Cash Flow Ratio = Share Price / Cash Flow from Operating Activities per Share (TTM) = 287.38 / (33.79 / 2.85) = 24.23

Price-to-Cash Flow Ratio = Market Cap / Cash Flow from Operating Activities = 873.83 / 33.79 = 25.86

4. As compared to 57.7 in 2019, Facebook’s P/CF figures have clearly improved.

5. Now let’s compare it to other similar companies belonging to the same sector:

Spotify Technology SA — 112.60;
Twitter Inc — 36.41;
Twilio Inc — 1,442.94.

The comparison reveals that Facebook’s P/CF can be considered sufficient as far as its sector goes.

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Interpretation

Despite the lack of consensus on what can be deemed as the best P/CF ratio, the notions below are considered universally accepted:

A higher ratio indicates that the stock is potentially inflating the value of every dollar of free cash.
Under otherwise equal conditions, a lower ratio is considered better.
By using P/CF, you can get an idea of how much value you will get out of paying a certain amount of money. If you are planning to invest in a particular project, P/CF is one of the key indicators you should analyze since it helps to understand whether the company is overvalued or undervalued.
With the P/CF ratio, we can check out the cash flow from operating activities which is an accurate metric revealing how much cash went in and out of the company’s business activities. This is why a lot of financial analysts consider this ratio to be a more precise indicator of investment attractiveness as compared to P/E. Unlike cash flow, earnings can be easily manipulated since depreciation as well as other non-monetary factors affect them.
However, when the cash flow is involved, it changes the whole picture entirely. Non-monetary factors are not included in the cash flow statements and so the net cash flow cannot be manipulated at the end of the reporting period.
When calculating P/CF, we get a better idea of how much cash flow the company generated per share. We can then compare these figures with the price per share to decide whether it makes sense to invest or not.
P/CF can be applied in specific cases only. For instance, the use of operating cash flow in P/CF makes this ratio an excellent tool for evaluation of stocks of the companies with large non-cash expenses, e.g. depreciation.
In some instances, companies with positive cash flow do not generate profits because of the large non-cash expenses. P/CF ratio gives financial analysts and investors a less distorted picture of a company's financial standing.
In order to find the best ratio, we need to consider the industry the company in question belongs to. E.g. A tech startup will grow much faster which will result in a higher P/CF. If it is a utility company that has been operating for years, P/CF will be smaller.

Limitations

It stands to mention that this ratio has one significant limitation: it does not factor in capital costs. If you wish to measure this ratio, you need to move beyond P/CF, calculate free cash flow and compare it to the price per share.

Let’s sum things up

P/CF is a very handy indicator because it keeps the likephood of cash flow manipulation down to a minimum or fully eliminates it. Aside from that, it allows us to understand whether investing in a particular stock would be a sensible decision.

You may now wonder what metric is the most precise of all. This is the price-to-free cash flow (P/FCF) which we are going to unpack in our next lesson.

⇐ Secrets to making money with shares. Lesson 6. (P/S). Tesla Key to making money with shares. Lesson 8. (P/FCF). Google ⇒

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