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Monday, August 23, 2010

Cash Flow Ratio: A Better Measurement of Stocks Value

Cash flow ratios are a better measurement of a stock’s value than price earnings ratio (P/E).

How much cash a company can generate is one of the more important measures of its health. Yet, you will hear more about P/E than almost any other metric on valuation, but it does not give you an accurate picture of a company’s ability to generate cash.

P/E represents the ratio of the stock’s price to its earnings per share (EPS). It is an important metric, for no other reason because so many people think it is. When a company’s P/E is very high or low, it gets top billing on the news.

Overlooked by many are the equally important, we would suggest more important metrics that examine a company’s price relative to its cash position.

Importance of Cash

The reality is that without cash, a company won’t last long. That may seem obviously simple, however there is a long list of companies that failed because cash was in too short supply.

So, how do you use cash flow ratios to see if a company is under or over-valued, which is the same purpose of P/E? Two primary measurements shed light on a company’s valuation.

Price to Cash Flow

The price to cash flow is determined by dividing the stock’s price by cash flow per share. The reason many prefer this measurement is the use of cash flow instead of net income (found in computing EPS).

Cash flow is a company’s net income with the depreciation and amortization charges added back in. These charges, which reduce net income, do not represent outlays of cash so they artificially reduce the company’s reported cash.

Since these expenses don’t involve actual cash, the company has more cash than the net income figure indicates.

Free Cash Flow

Free cash flow is a refinement of cash flow that goes a step farther and adds one-time expenses capital expenses, dividend payments, and other non-occurring charges back to cash flow. The result is how much cash the company generated in the trailing twelve months.

You divide the current price by the free cash flow per share and the result describes the value the market places on the company’s ability to generate cash.

Like the P/E, both of these cash flow ratios suggest where the market values the company. Lower numbers relative to its industry and sector, suggests the market has undervalued the stock. Higher numbers than its industry and sector may mean the market has overvalued the stock.

Thankfully, you don’t have to do all of these calculations. Many sites on the Web include these valuation numbers for your consideration.

Like all ratios, they don’t tell the whole story. Be sure you look at other metrics to verify relative value. However, these cash flow ratios can give you significant clues to how the market values a stock.