Cash flow vs. P-E: Two ways to look at value

by Matt Krantz

Q: When analysts say a company is selling for 45 times its cash flow, how do they calculate that and what does it mean?

A: Some investors believe that cash is king.

While many decide if a stock is cheap or expensive based on its price-to-earnings (P-E) ratio, others make the call by comparing a stock price to the amount of cash a company generates. This valuation based on cash flow is called the price-to-cash flow ratio or cash flow multiple.

The basic idea here is that the true health of a company is better measured by the cash it generates than by the earnings line in a quarterly report. Earnings include many non-cash items that are bookkeeping oriented. So some experts insist price-to-cash flow is a more accurate measure of a company’s valuation.

Many individual investors don’t use price-to-cash flow because it’s not as readily available as the P-E. And calculating a company’s cash flow takes a little effort.

To get the price-to-cash flow ratio, divide the stock’s market value by the cash flow you calculate. You can get any stock’s market value, also called market capitalization or market cap, by entering the stock symbol or company name in the Get a Quote box at the top of this page.

Interpreting the price-to-cash flow ratio is similar to P-E. The higher a P-E, the more highly valued the company is. With price-to-cash flow, the higher the number the steeper premium investors are paying for the stock. To use your example, if a stock has a price-to-cash flow of 45, that means investors think every $1 in cash flow generated by a company is worth $45.

Source: USA Today

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