My Favourite Simple, Down and Dirty Valuation Metric

My Favourite Simple, Down and Dirty Valuation Metric

And the answer is Price to Cash Flow…more accurately, Price to Operating Cash Flow…

Why use cash flow? Well for one thing it is a very easy and convenient metric to get off the internet, and it is steadier and not nearly manipulated as much as earnings. Cash Flow represents a more accurate picture of a company’s profit potential because it simply shows how much actual cash is flowing in and out of a business, whereas earnings, being an accounting concept are subject to a lot of adjustments, not to mention, estimates, assumptions and sometimes outright manipulation.

Cash flow is not affected by noncash charges that come from a corporate restructuring or an asset write-down. It also takes capital efficiency into account in some ways, because companies that need less working capital to grow will usually have higher cash flow than earnings. One thing cash flow does not do is take depreciation into account, so asset-intensive companies will often have higher cash flow than earnings, which can overstate their profitability because those depreciated assets will need to be replaced someday...

Cash flow is also what private equity investors focus on while trying to value a business.

One thing I’ve learned from investing over the years is to keep things simple. Why knock yourself out analyzing a company in depth when randomness can come along later and render it all meaningless. Price to Cash Flow is a simple but solid number to use to get a quick read on the current value of a company. If an investor can then do some trend analysis and see how that number compares with previous values over the years, he get an even better feel for the value of a company. He could also compare a companies’ price/cash flow with other companies in the same industry…This metric has served me well over the years.

My favourite site for this ratio is Morningstar where an investor can see a ten year history of this valuation ratio…Please see an example of this below for Open Text which is one of my biggest holdings…

http://financials.morningstar.com/valuation/price-ratio.html?t=OTEX&region=usa&culture=en-US

You will notice under the ratio history there is another ratio called ‘Cash Return’ which is a yield based valuation number…

The cash return tells an investor how much free cash flow a company is generating relative to the cost of buying the whole company, including its debt burden. To calculate cash return, add free cash flow (cash flow from operations, minus capital expenditures) to net interest expense (interest expense minus interest income). That’s the top half of the ratio. The bottom half is called “enterprise value”, which is the company’s market capitalization (equity) plus long-term debt, minus any cash on the balance sheet.

The goal of the cash return is to measure how efficiently the business is using its capital – both equity and debt – to generate free cash flow. Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole company, including its debt burden.

The beauty of yield-based numbers is that you can compare them directly with alternate investments, like bonds…for instance we can see from above that Open Text has a cash return of 5.7 percent. When that yield is compared with what an investor can currently get from the ten-year bill (the risk-free rate) it looks like a very attractive investment.

At the recent four year low (see  blogposts previous) there were all kinds of companies trading at ridiculously low price to cash flow numbers…This helped confirmed the validity of the four year low itself…it was a great time to pick up quality merchandise at discount prices…in other words…buying cheap!

One more thing...these metrics are to be used on operating companies only, not financials...Financial conpanies have to be valued in a different way, I guess valuing financial companies would be a good topic for a future post....The best way to learn something is to teach it...

Resources,

The Little Book that Builds wealth,

Pat Dorsey