The price-to-earnings ratio (P/E) is probably the most common ratio in determining whether a company is under or overvalued. However, price-to-cash flow (P/CF) is another great ratio for finding value stocks.
Cash, of course, is vital to a company’s financial health in order to finance operations, invest in the business, etc.
And cash can’t really be manipulated on the income statement like earnings can.
The reason why some like this measurement better than the P/E ratio is because the net income of the cash flow portion rightly adds depreciation and amortization back in, since these are not cash expenditures.
Whereas the net income that goes into the earnings portion of the P/E ratio does not add these in, thus artificially reducing the income and skewing the P/E ratio.
So many analysts prefer using the price-to-cash flow metric to judge a stock’s value.
And just like the P/E ratio is calculated by dividing the price by its earnings per share — the price-to-cash flow ratio is calculated by dividing the price by its cash flow per share. Also like a P/E ratio, the lower the number, the better.
Currently, the average P/CF for the stocks in the S&P 500 is 14.06. But just like the P/E ratio, a value of less than 15 to 20 is generally considered good.
In my testing, I have found that a P/CF between 0-10 produced the best results (17.1% over the last 10 years (using a one-week rebalancing period). The second best results came with the range of 10-20 with a 10.2% gain. However, once you get over 30, the odds point to a loss (-2.8%). And over 40, the odds of loss are even greater at -6.9%.
By the way, if you add the Zacks Rank to that first range, the results increase to 34.7%. Pretty awesome.
This being said, though, I still like also comparing the stocks’ P/CF to its industry, as different industries will have different numbers that are considered normal.
For example: for computer-software companies, the median price-to-cash flow is 18.51, whereas for telecom it’s 6.9.
The screen I’m running today is relatively simple:
- Zacks Rank Equals 1 (Only Strong Buys get thru.)
- One-Year Projected Growth Rate Greater Than or Equal to Average for the S&P 500 (Looking for above market growth rates.)
- Current Cash Flow Greater Than or Equal to 5-Year Average Cash Flow (I want to see the company’s cash position improving.)
- Price-to-Cash Flow Less Than or Equal to Median for Its Industry (Want to see companies with valuations lower than the median for their respective groups.)
Here are 5 stocks that came through this week’s screen:
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.
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