Price to Cash Flow
The price to cash flow ratio is a valuation tool used to assist buyers and sellers of stock in determining timing of purchases or the disposition of shares. Unlike the other valuation ratios, this particular ratio utilizes the cash flows statement in determining the outcome. The formula is simple:
Price to Cash Flow = $Market Price of a Share of Stock
Cash Flow in Dollars Per Share of Stock
To illustrate, lets take a look at the price to cash flow for a share of Walmart stock. The current price for a share of Walmart stock is $98.87 (noon) on 03/21/19. The most recent reporting of cash flow from their 4th quarter 2018 financial statements is $17.4 Billion for the year (Ending on 01/31/19). Total number of shares in the market on the same date are 2.9 Billion. Therefore:
Price to Cash Flow (Walmart) = $98.87 = $98.87 = 16.48:1
$17.4/2.9 Billion Shares $6.00
As the cash flow per share increases, the formula’s outcome decreases. At $7.00 per share of cash flow, the ratio decreases to 14.12:1. In effect, the lower the ratio, the more valuable the share becomes at the current market price. Similar to all valuation ratios, as the valuation ratio decreases, there is greater incentive to buy the stock. As the ratio increase, it behooves the owner of stock to sell the share. Therefore there is a key investment principle here, an investor should constantly monitor the trend line related to this ratio, for that matter, all valuation ratios should have trend lines and the results are monitored constantly to trigger buy and sell decisions.
This leads to several issues related to this ratio. First off, is it a good ratio to work with, can it be improved and what is the best way to utilize this formula? The second section below evaluates this formula in detail. Secondly, is there a proper way to apply the formula? The third section explains this in detail and will also address timing issues and more. Finally, how does this ratio relate to the other valuation ratios and where does it rank in the hierarchy of business ratios.
One last thing before digging into the details. Many readers will not be well learned about cash flow and how it is calculated or even why it is calculated. Therefore, there is an introductory section that covers cash flow; for those of you already well versed in the nuances of cash flow, please skip the introductory section and move onto ‘Price to Cash Flow – A Mature Approach’.
Understanding Cash Flow
This one area of accounting is probably the most difficult to comprehend even for the most sophisticated entrepreneurs. The primary purpose of providing a cash flows statement to readers of financial reports is to help the user understand where any increases or decreases in cash stem from with the company. In small business, its purpose is the conversion of accrual accounting to cash accounting. It helps the owner to evaluate why the business increased or saw decreases in the overall cash position.
The cash position is the primary starting point. Basically, the reader wants to understand why the cash position changed during the accounting period. For example, using the Walmart illustration above, on February 1, 2018 at 12:01 AM (the first day of the Walmart’s 2019 fiscal year), Walmart’s cash position was $7,014,000,000 ($7.014 Billion). On January 31, 2019, Walmart’s cash position improved to $7.756 Billion, a $742 Million increase.
How did this happen? In order to understand, the user must first understand how a cash flows statement is presented.
The cash flows statement is divided into three major sections:
- Cash Flows from Operations
- Cash Flows from Investing
- Cash Flows from Financing
The following explains these sections in a summary format.
Cash Flows from Operations
This section of the cash flows statement is commonly called the cash flows from operating activities. It represents the net profit and adjustments to reflect cash earned from normal business. For investors, you really want this part of the cash flows statement to be positive. It means, the company is generating enough profit to pay bills and meet their current operational cash needs. Smaller businesses and penny stock companies often do not have positive cash flow from operations. This is because their growth, which demands cash, is paid from operational income. Thus, smaller companies should have significant profit margins to augment growth.
Large companies like Walmart will and should always have large sums of cash provided by operations, typically driven by their profits. In Walmart’s case, during 2019, Walmart had a profit of $7.2 Billion and this is after depreciation of $10.7 Billion. With other adjustments, cash flows from operations were $27.75 Billion that year. This is sourced from their unaudited financial report via Form 8-K dated February 19, 2019.
Cash Flows from Investing
Investing activities are different. Your common layman would say it means the purchase of stocks and bonds. But most companies are not in the business of buying stocks and bonds. They are in the business of making a profit. To do this, they must invest in additional stores or warehouses, distribution systems, manufacturing equipment and so on. Utility companies spend money on new or replacing existing power plants and distribution systems. In Walmart’s case, they add stores, buy up existing businesses, invest in new revenue lines of operations and more. In general, most companies have to spend money related to investing. In most cases, this part of the cash flows statement has a negative or outgoing spending of cash. During 2019, Walmart net investment into fixed assets and new lines of businesses equaled $24 Billion.
Think about this for a minute, they made $27.75 from regular operations and spent $24 Billion of that to add new or modify existing facilities and to purchase additional businesses.
Cash Flows from Financing
The financing section of the cash flows statement reflects borrowing of money and any cash payments related to stock. This includes the payment of dividends and the repurchase of stock. Stock may be bought back and permanently retired or it may be available for future sale, called Treasury Stock.
As companies mature and move into the top 2,000 companies worldwide, this section of the cash flows statement is often negative. Why? Well, over time, as companies mature and expansion becomes more difficult or expensive, the shareholders begin and demand a return on their investment via dividends. Recently, many companies have started to buy back stock as excess cash is not needed and so the best tool is to decrease the volume of existing stock in the market. In Walmart’s case, during 2019, Walmart used $7.4 Billion to buy back 80 Million shares. Take note, Walmart had over 3,000,000,000 (3 Billion) shares outstanding (held by investors) at the beginning of fiscal year 2019. In addition to buying back stock, Walmart paid $6.5 Billion in dividends to existing shareholders, about $2.08 per share.
In total, Walmart had to borrow money to facilitate investing activities above and to ensure payment of dividends and the repurchase of stock. This makes sense, in total, Walmart borrowed $15.9 Billion and made principal payments of $3.8 Billion for a net borrowing of $12.1 Billion. If you look up in the investing activities section, Walmart spent $24 Billion for investing activities and funded this with $12.1 of net borrowings. Other financing items required the use of $491 Million. Altogether, cash flows from financing used $2.5 Billion.
When you add up all three major sections and adjust for currency rate exchanges (Walmart operates almost worldwide), cash increased $742 Million.
If you want to look at this in more detail, here is the link to Walmart’s K-8 Report on February 19, 2019. Scroll down to page 12 in the report which is page 9 of the consolidated financial statements. Please remember, these reports are unaudited and most likely will be audited by mid April 2019 and presented in the final annual report of Walmart for Fiscal Year 2019.
For the reader, remember there are three major sections of the cash flows statement, cash flows from operating activities is the most important of the three. For mature companies, this should be very positive.
For those of you requiring additional help in understanding cash flows, go to businessecon.org and search for cash flows. There are over 20 articles that cover cash flows from general concepts to a very intensive understanding.
Now that you have a general understanding of cash flows and the statement, it is now time to understand the price to cash flows formula in greater detail.
Price to Cash Flow – A Mature Approach
The price to cash flow flow formula has several advantages over other valuation ratios. First off, it is based on cash and not earnings. Earnings can be deceitful due to timing issues and more. For example, even though the company may have generated a profit from ongoing operations, it doesn’t necessarily mean it will realize that profit in the form of cash. Why? Well, sometimes the customer doesn’t pay their bill in a timely fashion. Recently, the U.S. government shut down, did they pay their bills to many vendors and contractors doing business with them during that one month hiatus? Nope, didn’t happen.
Also, profits are a derivative of estimates. With every set of financial statements are a set of notes. There are about 20 to 30 notes for publicly traded entities. One of those notes is a standard note that states that the company uses estimates to derive their profits. Estimates are used for determining useful lives of fixed assets, the value of inventory, and amounts owed for deferred items such as taxes and employee benefits. All of these items directly affect the profit of the company. Thus, the profit can be way off, often its close, but it could be over or understated.
A good example of how profit can be greatly misstated relates to unforeseeable accidents. Recently, California experienced a costly fire known as the Camp Fire. This fire was started by PG&E’s (a utility company) electric sub station. This forced the company into bankruptcy. The company’s profit was estimated at $1.6 Billion for the nine months ending September 30, 2018. By the end of December 2018, the fire had caused an estimated $16.5 Billion in damages. Nobody could foresee this accident coming. Many accountants estimate some form of unforeseen future costs related to normal occurrences. PG&E didn’t set aside $16.5 Billion for a fire. This is an extreme example. But there are many others that happen and happen frequently.
Non-Recurring Items – these are one time adjustments usually related to a compliance issue or a monetary exchange situation. Other non-recurring items include impacts to profit for international situations such as civil unrest, wars and governmental actions.
Market Adjustments – fair market value is elusive and thus companies may have to adjust the value of their assets such as inventory or real estate due to market conditions.
Discontinued Operations – with this form of profit adjustment, the company has decided to stop performing operations by shutting down a plant or deciding to convert to a new or different line of business.
The above are extremes, but it is designed to illustrate to the reader that often, profit is merely an estimate. However, cash is not an estimate. Cash is the hard truth. This formula is grounded in the concept of cash and not profit. Thus its importance within the valuation group is often downplayed due to its complexity. For the sophisticated investor, it should be one of the top five ratios to rely on for stock transactions. Many investors don’t use this ratio because they don’t really understand how to calculate the ratio.
Proper Application of the Price to Cash Flow Ratio
Let’s go back and revisit the formula:
Price to Cash Flow Ratio = Current Market Price for a Single Share of Stock
Cash Earnings Per Share of Stock
At first glance, it appears simple. To acquire the numerator, just look up the current market price per share. It is constantly changing, thus this formula is always in a state of flux. Its the denominator that is the difficult part of the formula to determine. One simple way to do this is to look at the cash flows statement and look at the bottom line. If you opened the Walmart report, the cash flows statement states that in 2019, Walmart generated a positive $742,000,000 in cash. Here is a simple snapshot of that line from the report:
Net increase (decrease) in cash, cash equivalents and restricted cash 742
The values are in millions of dollars.
Now, you simply divide this value by the number of shares to get the cash earnings per share. There are 2.9 Billion shares outstanding, therefore, each share earned 25.6 cents in cash.
That does not seem like a whole lot does it? If we insert this into the formula and use the trading price from 03/22/19 this is the result:
Price to Cash Flow Ratio = $98.87 = 386:1
$00.256 (25.6 cents per share)
The ratio is 386 to one. This is a crazy number to work with. This can’t be right.
Actually, its worse than that. Take a look at the report, look at the 2018 column. In 2018, Walmart’s total cash flow was a negative $130,000,000. This would mean each share lost money for the company in terms of cash flow. How do you divide a positive numerator by a negative denominator? In math, it is referred to as a negative fraction and it will not work with business ratios.
Therefore, the first obvious requirement for the price to cash flow ratio if using total cash flows is that the cash flow has to be positive. This doesn’t happen every year and therefore as an investor, you can’t get a consistent trend line. It is common for large corporations to have decreases in cash from one accounting period to the next. It doesn’t mean they are performing poorly, it just means they utilized the cash for other purposes such as paying down debt, purchasing fixed assets and so on.
How does an investor address this then? What is the proper value to use in the price to cash flow formula?
The answer to both questions is ‘Free Cash Flow’. Free cash flow is the amount of cash a company generates from operations less amounts spent on capital expenditures. This simply means that cash available to reduce debt or release to shareholders is discretionary.
With most companies, capital expenditures are necessary to maintain facilities or maintain market position. For example, with the transportation sector, it is necessary for companies to replace units within the aging fleet. Capital expenditures are a normal and necessary function of every major company in the world. Therefore, cash from operations is used to fund these capital expenditures. Yes, the company can indeed borrow money to fund the capital expenditures. This merely binds the company to additional requirements on future cash flow. An investor wants to really know how much is truly free to use in the current period. Thus the term ‘Free Cash Flow’.
With Walmart, cash flows from operations was $27.75 Billion. Walmart had to spend $10.34 Billion on new or upgrades to facilities, equipment, distribution systems etc. Therefore, free cash flow was $17.41 Billion.
Some of you may wonder why debt reduction isn’t included in the formula. Although it appears logical, debt reduction can simply be replaced by borrowing the same amount to pay down the debt. Debt in large companies can be easily neutralized by swapping existing debt. In reality, this is normal. When a bond is issued, it is often replaced with a new bond of similar face value upon maturity. Thus, debt is excluded in the formula.
Another exclusion is the investment for new business lines or the purchase of existing businesses. It would seem reasonable to include these capital expenditures as a deduction from operations. But the logic is simple, how much of the cash earnings from operations is used to fund the replacement of existing assets or depleted assets via capital expenditures. Expansion is a decision based on how the investors want the company to exist in the future. In most cases, there is a general understanding to invest some money into growth and return some money to the shareholders. Walmart follows this pattern. In 2019, Walmart spent $14.7 Billion to acquire new businesses. Expansion is excluded from the formula.
If free cash flow is negative, as an investor, you will want to seriously investigate why. Stay away from purchasing stock in companies with a negative free cash flow.
Here are some examples of similar businesses and their respective cash flow earnings per share and the price to cash flow outcomes:
- Walmart (Jan 31, 2019 FY End) – 16.5:1 (See Above and Sourced From Unaudited Financials as Reported on Form 8-K)
- Target – (Feb 2, 2019 FY End) $78.32 (Close of Business on 03/22/19) = 37.3:1
. $2.10 - Costco – $237.56 (Close of Business on 03/22/19) = 49.6:1
. $4.79 - Kroger – $24.34 (Close of Business on 03/22/19) = 25.62:1
. $.95 (95 Cents)
When evaluating the above, remember there are other circumstances that affect the cash flow per share thus impacting the ratio. DO NOT USE THE PRICE TO CASH FLOW RATIO AS THE SOLE DECISION FORMULA. For example, in 2018, Target’s Form 10-K reveals that the company spent $1 Billion more on capital expenditures than it took for depreciation. This means that had they matched their depreciation similar to how Walmart’s capital expenditures and depreciation were somewhat similar, Target’s free cash flow per share would have been $3.95. Now let’s see the adjusted results:
Price to Cash Flow (Target for 2019 FY End) = $78.32 = 19.83:1
$3.95
Walmart actually had $300,000,000 more depreciation than its capital expenditures for the same time period. Thus, Walmart’s Price to Cash Flow can be restated as:
$98.87 = $98.87 = 16.76:1
$17.1 Billion/2.9 Billion Shares $5.90
Now the formulas are more in line with each other and can be fairly compared. In this case, Walmart is a better ratio than Target’s; but Target is significantly better than other large retailers.
Price to Cash Flow as a Valuation Ratio
In the author’s opinion the price to cash flow ratio is a superior ratio within the group of valuation ratios. There are several reasons for this opinion:
- The ratio is based on cash and not an estimated value of profit.
- The formula requires knowledge of cash flow within the corporate financial statements and therefore requires the user to do some analytical processing prior to implementing the formula.
- Many investors don’t truly appreciate cash flow as a value determinate, thus those that apply this formula correctly have a distinct advantage over others.
- The price to sales ratio has several drawbacks with its use and thus has no significant contribution as a valuation ratio.
Because the price to cash flow ratio requires an understanding of the cash flows statement and operational issues, proper application of this formula provides the user with a distinct advantage over other investors. It is the author’s opinion that this particular ratio should be one of the top five used by every investor. ACT ON KNOWLEDGE.