Many investors view price/operating cash flow (P/OCF) ratio as the best
of the four valuation ratios—and they may have a point.
Remember how companies can skew reported earnings using
accounting tricks? Cash flow doesn’t leave them many loopholes. To
calculate operating cash flow (don’t worry, you can pull the final data from
the Internet without calculating it yourself), companies start with earnings
and then strip away costs that aren’t paid in cash as well as other noncash
adjustments. Operating cash flow—also called cash from operations—
reflects the amount of cash a company’s operations generate.
While aggressive accounting methods can skew earnings (and to a lesser
extent, sales), and book value becomes less accurate over time, the P/OCF
ratio probably offers the cleanest, most accurate picture of a company’s
valuation. When a company grows earnings but doesn’t grow cash flow,
investors should become suspicious. If a stock you’re considering looks
cheap based on the P/E ratio, but expensive on P/OCF, the company might
have resorted to accounting shenanigans to boost earnings and make its
growth look stronger.
To calculate the P/OCF ratio, divide stock-market value by the operating
cash flow generated over the last four quarters. You’ll find operating cash
flow in the statement of cash flows presented online, again summing the last
four quarters. For example, at 12.3 times operating cash flow, Pfizer is
cheaper than one of its peers and more expensive than two others.
When you use the P/OCF, remember these points:
Plenty of companies generate negative cash flows, rendering the ratio
Many companies don’t report cash-flow data—at least not in a way that
is accessible to beginning investors. In particular, banks and utilities
tend to skimp on providing that kind of information.
Not all companies calculate cash flow the same way internally. While
federal accounting rules provide guidelines, many companies present
their own customized numbers in addition to those mandated by the
government. When you compare companies using P/OCF, make sure
you collect similar numbers for the different companies. Your best
option is to pull the data directly from the statement of cash flows—not
from the text in a company’s earnings release.
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