Price-To-Cash Flow (PCF)

The PCF of a company indicates how much annual cash flow you are buying per share. A high PCF shows that cash flow is slim in relation to the share price. Conversely, a low PCF is usually very attractive. If the PCF is much higher than the PER, the causes of the difference need to be established.

From an accounting point of view, a company's ability to pay investors an increasing flow of dividends is determined by its profitability. In practice, however, a more important measure of its financial health is its cash flow.

The PCF, in itself, does not indicate a strong cash flow; it simply tells you if the share price is high or low in relation to it.

A company's net cash flow has to fund the following:-

1. Repayment of any loans
2. Future capital expenditure
3. Dividends on ordinary shares.

Cash flow is a key measure of the capacity of a business to service these requirements, helping to highlight:-

• a) If creative accounting has been at work. (This is determined by seeing if there is a major disparity between the trend of cash flow and EPS on a normalised basis, i.e. excluding non-trading profits and losses).
• b) If the future dividend is safe. Earnings are usually more volatile than cash flow and there is a greater relationship between cash flow and dividends than between cash flow and earnings.
• c) Future liquidity and gearing. Cash flow is the raw material that will be used to pay off debts and improve liquidity. Without an adequate supply, gearing will increase and liquidity will deteriorate.
• d) If a company has been over-trading. If earnings per share are expanding rapidly and cash flow is shrinking, this can indicate over-trading; for example, excessive funds may be locked up in growing debtors. This, in turn, raises the question of whether credit policy is too lax or customers are unable to pay.
• e) If future expansion plans and proposed capital expenditure can be funded from within. This, in turn, is a kind of cross-check on the validity of a high PER linked to expansion plans and capital expenditure.
  
  Capital expenditure requires special attention. It is accepted as an appropriation rather than as a charge against cash flow. However, in some cases capital expenditure is necessary for the continuance of a business (e.g. the replacement of old machines with new ones for the same purpose).
  
  Capital expenditure on brand new machines for a new and additional factory is quite another matter. Unfortunately, it is not possible to distinguish readily between capital expenditure on expansion and on necessary replacement. Investors should, therefore, keep an eye on the level of capital expenditure each year and try to determine from broker and press comment how much of it is expansionary (as opposed to necessary replacement).

PCF is calculated by dividing a company's market capitalisation by its cash flow. In REFS, cash flow is derived from the Cash Flow Statement, which is a mandatory requirement imposed by the Accounting Standards Board.

The Cash Flow Statement splits cash flow into different categories and classifies sources of movements into their economic causes. Headings include Net Cash Inflow from Operating Activities and this figure must be reconciled with operating profits. Apart from depreciation and associated company profits, the main additional items are increases and decreases in
stocks, debtors and creditors. A typical reconciliation might be as follows:-

If the company's market capitalisation was £15.0m, this would mean that the PCF was

Jim O'Shaughnessey, in What Works On Wall Street, found that during the period 1954-1994, stocks with a low PCF gave an average annual return of 13.58% against a market average of 12.45%. Conversely, stocks with a high PCF gave a very poor return of only 6.80%.