Last week in this column, I discussed why I do not believe the market is in a bubble. I offered several reasons, among them that the market’s price-to-earnings (P/E) ratio was not in bubble territory.
P/E is the most popular method of valuing a company. You take the company’s earnings per share and divide it by its stock price.
For example, over the last 12 months, Google (Nasdaq: GOOG) earned $19.09 per share. As I write this, its stock is trading at $570.93. We divide 570.93 by 19.09 and get 29.9. That means that the stock is trading for 29.9 times its trailing 12 months’ earnings.
[ad#Google Adsense 336×280-IA]But if you’ve read my work for even a little while, you know I’m all about cash flow, not earnings.
There are several reasons for this.
As a dividend investor, I want to see that a company has ample cash flow to pay the dividend.
Earnings don’t represent actual cash that comes into the company. Cash flow does.
The second reason is earnings are more easily manipulated by savvy CEOs and CFOs.
Earnings contain all kinds of non-cash expenses. Things like depreciation, amortization and stock-based compensation are expenses that affect earnings, but do not impact cash flow.
That’s why cash flow is a more accurate representation of a company’s performance. So you want a way to value a company based on cash flow.
Fortunately, you calculate price-to-cash flow (P/CF) the same way you do P/E, although you may have to do a little more digging.
Companies typically don’t report cash flow per share. That’s something you need to calculate on your own. But don’t worry, it’s very easy.
You’ll find a company’s cash flow reported on its statement of cash flows. Just divide it by the number of shares outstanding (found on the income statement) to figure out what the cash flow per share is. Then, just like the P/E calculation, you divide the price of the stock by the cash flow per share.
Another way you could do it is by dividing the company’s market cap by cash flow.
Let’s take a look at Google:
Over the past 12 months, Google’s free cash flow was $20.3 billion. The company has 686 million shares outstanding. We divide 20.3 billion by 686 million and get 29.6. So the company’s cash flow per share is 29.6. Then we divide the stock price of $570.93 by 29.6 and get 19.2. So the stock is trading at 19.2 times cash flow. Similarly, if we divide the stock’s market cap of $387 billion by cash flow of $20.3 billion, we get 19.1. The difference is due to rounding.
How to Use Price-to-Cash Flow
Generally speaking, a stock with a P/CF under 10 is considered inexpensive. But like any valuation metric, it doesn’t exist in a vacuum. In other words, a stock’s or index’s P/CF should be compared to other stocks’ or indexes’ price-to-cash flow, historical averages, highs, lows, etc.
There will be times when a stock’s P/E is pricey but its P/CF represents value. In fact, that’s what’s going on with the market right now.
As I discussed with my colleague Steve McDonald recently, the market looks a little expensive on a P/E basis. Let’s see how it stacks up on a P/CF basis.
The S&P 500’s P/CF is 10.7. The average over the past 20 years is 11.6. So the market is trading 8% below its 20-year average. Over the past 10 years, the average is 10.6, so the market is trading right at its 10-year average.
Just like with a P/E ratio, you can search for stocks with low P/CF to get a list of cheap stocks.
I set up a screen for stocks with a P/CF less than 10, whose cash flow has been growing each year for the past three years and have a minimum market cap of $500 million. The screen came up with 338 names.
Among them:
- Airline Alaska Air Group (NYSE: ALK)
- Software company Premier Global Services (NYSE: PGI)
- Electric utility Wisconsin Energy Corp. (NYSE: WEC)
Although P/E is the most common way to measure market value, it isn’t the only way, or the best. Cash flow is a more accurate reflection of a company’s performance, so start there.
Good investing,
Marc
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Source: Investment U