Business, Legal & Accounting Glossary
The Price/Cash Flow (P/CF) Ratio is a valuation metric used by quantitative analysts and investors to evaluate a company’s market value relative to its operational cash flow.
The Price/Cash Flow (P/CF) Ratio is a valuation metric used by quantitative analysts and investors to evaluate a company’s market value relative to its operational cash flow.
The formula for Price/Cash Flow Ratio first calculates the cash flow per share. Then the current price is divided by the previous result.
There are multiple versions of the metric depending on the type of cash flow and time period used. Variants are summarized below:
The quarterly figures are more responsive than the trailing twelve months but are subject to seasonal variations. For this reason, they should only be used to compare stocks within an industry or sector.
In general, the P/CF Ratio provides an indication of the health of the company and the premium the market is willing to pay. A higher figure indicates that the market has high hopes for the future of the company. However, a high ratio may not signify a good investment due to share overpricing.
A lower ratio indicates that the market does not have as much confidence in the company. This may not always be a negative investment factor because the share price may be undervalued.
The Price/Cash Flow Ratio is considered by many analysts to be better than the more popular Price/Earnings (P/E) Ratio, as the former only considers cash flow, with non-cash items that are easy to manipulate removed from the calculation. In the case of large companies, depreciation and amortization tends to be large and greatly affects net income. This is reflected in the P/E Ratio and leads to poor investment decisions. On the other hand, the Price/Cash Flow Ratio removes the effect of non-cash items and gives realistic and reliable results.
A better measure is the Price/Free Cash Flow (P/FCF), a variant of the P/CF Ratio, which uses free cash flow instead of operational cash flow. The free cash flow is reduced by capital expenditures and other non-recurring items. Due to the complexity of calculating free cash flow, many investors prefer to use the simpler P/CF Ratio.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Price/Cash Flow Ratio is such a factor, having been correlated with past stock returns for the last 20 years and also expected to be correlated with future returns.
The P/CF Ratio exhibits the best quantitative characteristics when analyzed using a longer investment horizon. For quantitative analysis, the investment horizon is referred to as “rebalance period”. The rebalance period is the time a stock is held prior to refreshing the portfolio holdings. While the P/CF Ratio achieves good results with weekly, monthly and quarterly rebalance, the P/E Ratio performs best with an investment horizon of 1 year. This is explained further in the next section.
The Quantitative Analyst assesses individual stock factors by:
Ideally, the performance spread should be “monotonic”, meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, the stocks from the Russell3000 Index were sorted into quintiles based on Price/Cash Flow Ratio, then evaluated over the 10-year back-test period 2005-2014 with a 3 month and 1 year rebalance period.
P/CF
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This glossary post was last updated: 23rd March, 2020 | 0 Views.